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CORPORATION 
FINANCE 


BY 


EDWARD   SHERWOOD    MEADE,  Ph.D. 

WHARTON  SCHOOL  OF  FINANCE  AND  COMMERCK, 

UNIVERSITY  OF  PENNSYLVANIA 

AUTHOR   OF   "TRUST   FINANCE'.' 


NEW    YORK    AND     LONDON 

D.     APPLETON     AND     COMPANY 

I  9  I  o 


QENERAL 


Copyright,  1910,  by 
D.  APPLETON  AND   COMPANY 


Printed  in  the  United  States  of  America 


TO 

J.   LAURENCE   LAUGHLIN 


208564 


PREFACE 


A  RECENT  computation  showed  $34,763,000,000  par  value 
of  securities  issued  by  American  railway  and  industrial  cor- 
porations and  now  outstanding.  These  securities  have  been 
originally  employed  in  obtaining  capital  for  enterprises  or- 
ganized under  the  corporate  form,  or  in  enabling  the  owners 
of  properties,  or  the  promoters  and  financiers  of  new  projects 
to  realize  their  profits,  or  to  distribute  to  the  owners  of  cor- 
porations the  accumulated  profits  of  the  past,  or  in  exchange 
for  other  securities  which  it  was  found  necessary  to  retire. 
The  amount  of  income  which  these  corporations  receive  is 
estimated  at  $4,572,000,000.  An  increasing  share  of  Ameri- 
can property  is  represented  by  stocks  and  bonds.  An  in- 
creasing proportion  of  American  income  is  taking  the  form 
of  interest  and  dividends. 

The  enormous  and  increasing  values  and  profits  repre- 
sented by  American  business  corporations  have  attracted  gen- 
eral attention  to  corporate  activities.  The  problem  of  cor- 
poration regulation  is  perhaps  the  leading  issue  of  the  day. 
Each  of  the  leading  political  parties  is  committed  to  pro- 
grams of  corporation  control,  particularly  in  the  field  of  pub- 
lic-service corporations.  Many  laws  have  been  passed  to 
supervise  the  activities  of  corporations,  to  control  the  admin- 
istration of  corporate  income  and  expenses,  and  to  limit  capi- 
talization.    One  of  the  most  important  elements  of  our  eco- 


vu 


viii  PREFACE 

nomic  life,  the  business  corporation,  is  being  taken  under  the 
direct  supervision  of  the  Government. 

As  yet,  however,  this  control,  regulation,  and  direction  has 
proceeded  with  only  a  partial  understanding  on  the  part  of 
legislators  and  administrators  of  the  constitution  and  opera- 
tions of  the  institution  with  which  they  are  dealing.  The 
best  and  most  recent  evidence  of  the  inadequacy  of  knowledge 
upon  the  subject  of  the  financial  methods  of  corporations  is 
the  authorization  by  Congress  of  a  commission  to  inquire  into 
the  circumstances  connected  with  the  issue  of  securities  by 
American  railroad  companies.  It  is  the  task  and  duty  of  the 
American  college  and  university  to  do  its  part  in  dissemi- 
nating among  our  people,  through  the  students  who  pass  un- 
der its  direction,  correct  and  comprehensive  information  con- 
cerning all  phases  of  our  economic  life.  To  assist  this  work 
in  the  field  of  Finance  this  book  has  been  prepared. 

"  Corporation  Finance  "  is  designed  as  a  college  text-book. 
It  aims  to  explain  and  illustrate  the  methods  employed  in  the 
promotion,  capitalization,  financial  management,  consolida- 
tion, and  reorganization  of  business  corporations.  Of  neces- 
sity, the  treatment  of  this  extensive  subject  can,  in  no  part, 
be  exhaustive.  A  volume  as  large  as  this  could  be,  and  I  hope 
will  be,  written  by  investigators  upon  the  subject  outlined  in 
each  chapter.  Neither  have  I  attempted  to  deduce  from  the 
facts  of  Corporation  Finance  any  new  laws  or  principles.  All 
that  I  have  tried  to  do  is  to  describe  in  as  much  detail  as  the 
subject  permits,  the  methods  employed  in  Corporation  Fi- 
nance, to  indicate  the  working  rules  of  procedure  and  man- 
agement which  govern  these  methods,  and  to  show  some  of 
the  dangers  which  lie  in  ignorant  and  careless  financial 
management. 


PREFACE  ix 

The  treatment  of  the  subject  follows  the  natural  line  of 
corporation  development.  We  begin  with  the  investigation  of 
a  business  proposition.  Control  of  this  proposition  is  secured 
by  a  promoter,  a  financial  plan  prepared,  the  cooperation  of 
bankers  secured,  and  the  securities  are  sold.  The  next  group 
of  problems  encountered  relate  to  the  management  of  the  cor- 
porate income  in  order  that  a  regular  rate  of  distribution  of 
profits  may  be  made  by  the  directors  to  the  stockholders.  The 
methods  of  obtaining  new  capital,  directly  by  the  sale  of 
securities  and  indirectly  by  consolidation  with  other  com- 
panies are  then  examined.  The  last  part  of  the  book  deals 
with  the  procedure  in  corporation  bankruptcy,  and  with  the 
reorganization  of  the  capital  accounts  of  both  solvent  and  in- 
solvent corporations. 

The  material  of  the  book  has  been  mainly  taken  from  the 
Commercial  and  Financial  Chronicle.  Much  of  the  mate- 
rial has  been  included  in  the  text  in  its  original  form.  I  have 
reproduced  three  chapters  from  my  "  Trust  Finance  "  entire, 
and  have  made  large  use  of  the  lectures  on  Corporation  Fi- 
nance delivered  in  the  Harvard  School  of  Business  Adminis- 
tration in  1908-1909.  I  have  to  especially  acknowledge  my 
indebtedness  to  my  friend  Dr.  Thomas  Conway,  Jr.,  of  the 
Wharton  School  staff,  who  has  rendered  to  me  valuable  as- 
sistance throughout  the  preparation  of  this  book,  of  which  I 
desire  to  record  my  grateful  appreciation.  I  wish  also  to 
thank  Mr.  H.  Edgar  Barnes,  of  the  Philadelphia  Bar;  Mr. 
Ben  Loeb,  of  Sutro  Brothers  and  Company,  New  York;  Mr. 
Milton  W.  Lipper,  of  Arthur  Lipper  and  Company,  New 
York ;  Mr.  Roland  L.  Taylor,  of  the  Philadelphia  Trust,  Safe 
Deposit  and  Insurance  Company;  and  Mr.  George  Stevenson, 
of  Sailer  and  Stevenson,  Philadelphia,  for  advice,  suggestions, 


X  PKEFACE 

and  assistance.  I  wish  that  space  permitted  me  to  record  the 
names  of  a  large  number  of  my  friends  and  acquaintances  who 
have  placed  their  time  at  my  disposal.  Mr.  Albert  Hill  and 
Mr.  A.  W.  Taylor  have  greatly  helped  me  in  the  work  of 
revision  and  proofreading. 

I  have  inscribed  this  book  to  Professor  J.  Laurence  Laugh- 
lin,  of  the  University  of  Chicago,  as  a  tribute  of  my  appre- 
ciation of  his  work  as  a  teacher. 

E.  S.  M. 

Philadelphia,  September  22,  1910. 


CONTENTS 


CHAPTER  PAGE 

I. — Introduction 1 

II. — The  Work  of  the  Promoter               .  14  •'^ 

III. — The  Trust — Its  Promotion  and  Evolution    .  25 

a     IV. — Materials  of  Tdte  Financial  Plan    .       .  47*^ 

C      V. — The  Issuing  of  Securities 60 

C     VI. — State  Supervision  of  Security  Issues     .  72 

0     VII. — Provision  for  the  Repayment  of  Bonds        .  ~  81 

Q     VIII. — The  Issue  of  Stock 91  tX 

IX. — Methods  of  Paying  for  Stock   .       .       .       .103 

X. — The  Sale  of  Securities 118 

XI. — The  Sale  of  Speculative  Securities       .       .  131 

Q    XII. — The  Sale  of  Speculative  Securities  (Continued)  144 

p   XIII. — Underwriting 157 

^    XIV. — The  Determination  of  Profits  .  .       .169 

^      XV. — The  Determination  of  Profits — Depreciation  188 

0     XVI. — The  Management  of  the  Corporate  Income   .  208 
0  *^VII. — Fixing  the  Proportion  of  Profits  to  be  Paid 

Out  in  Dividends 226 

0     XVIII. — The  Methods  of  Distributing  the  Surplus  .  239     "/^ 

I?        XIX. — The  Provision  of  New  Capital      •  .        .        .  253    "^ 

O      '^XX. — The  Method  of  Providing  New  Capital  267 

Q         XXI.— The  Issue  of  Stock 277 

XXII. — The  Sale  of  Preferred  Stock    ....  290 

0    "^^XXIII. — The  Issue  of  Evidences  of  Debt     .       .       .  297 

0    •XXIV.— Long  Term  Bonds 304 

O    «^XXV.— Mortgage  Bonds 312 

xi 


xii  CONTENTS 

CHAPTER                                                                                                             .  PAGE 

O    ^  XXVI.— The  Collateral  Trust  Bond    ....  323 

O     XXVII. — Bonds  Secured  by  the  Assignment  of  a  Lease  330 

XXVIII. — Consolidation  of  Corporations       .       .       .  336 

XXIX.— The  Holding  Company 346 

XXX.— The  Lease 373 

XXXI. — Readjustment  of  the  Capital  Account        .  383 

XXXII. — Receiverships 404 

XXXIII. — The    Reorganization    of    Bankrupt    Corpo- 
rations      425 


u«mve:HsiTY 

OF  ^ 


CORPORATION    FINANCE 


CHAPTER   I 
INTRODUCTION 

Every  day  of  the  year  numerous  opportunities  for  the 
production  of  wealth  are  being  brought  forward,  deposits  of 
minerals  are  discovered,  franchises  obtained,  patents  granted. 
Railway  extensions  are  constantly  bringing  new  land,  timber, 
and  coal  into  the  market.  Increasing  population  offers  a 
basis  for  water,  light  and  transportation  plants.  New  inven- 
tions stimulate  new  wants,  and  these  wants  in  their  turn 
produce  new  means  of  satisfaction.  In  1900,  the  production 
of  bituminous  coal  in  the  United  States  was  172,600,000 
tons;  in  1908,  eight  years  later,  this  amount  had  more  than 
doubled,  rising  to  352,500,000  tons.  The  production  of  pig 
iron,  which  accurately  shows  the  increase  in  the  construction 
of  the  "  plant "  of  society,  during  the  same  period  increased 
from  13,600,000  tons  to  25,780,000  tons,  and  the  production 
of  steel  increased  in  practically  the  same  ratio.  -The  produc- 
tion of  lumber  in  thousand  feet  during  this  ittn  years  rose 
from  34,800,000  to  40,300,000. 

This  enormous  increase  in  the  production  of  fuel  and 
materials  signifies  not  only  rapid  growth  in  every  depart- 
ment of  industry  but  also  a  multiplication  of  the  opportu- 
nities for  money  making  of  which  producers  have  taken  ad- 
vantage. In  the  railway  field,  for  example,  the  mileage  of 
nearly  every  important  railroad  has  shown  a  large  increase 
within  the  decade  mentioned.  The  Baltimore  &  Ohio,  a 
typical  trunk  line  railroad,  in  1899,  reported  2,047  miles  of 
line,  45,764  cars  and  954  locomotives,  operating  in  a  terri- 
tory already  developed.    In  1908,  the  mileage  had  increased 

1 


2  COKPOKATION  FINANCE 

to  3,992,  the  cars  to  61,647  and  the  locomotives  to  1,396. 
Ten  years  ago  the  Intenirban  Electric  Eailway  was  in  its 
infancy;  to-day,  between  seven  and  eight  thousand  miles  of 
line  are  reported  as  in  operation,  a  new  industry  having  been 
created  within  the  decade. 

In  every  branch  of  industry  the  opportunities  for  making 
money  are  coming  forward  in  endless  variety.  Take  but  one 
field,  the  production  of  power;  we  find  here  a  vast  range  of 
opportunity  for  profitable  investment.  We  have  the  mechan- 
ical forced  draft  and  the  mechanical  stoker,  the  latter  in  a 
variety  of  types ;  the  use  of  superheated  steam  to  reduce  con- 
densation and  increase  the  efficiency  of  the  boiler;  the  steam 
turbine  to  utilize  the  direct  pressure  of  the  steam;  and  the 
various  devices  and  compounds  which  are  designed  to  purify 
the  water  before  it  goes  into  the  boiler.  In  other  divisions 
of  the  field  of  power  we  have  the  development  of  electric 
power  transmission  which  enables  electricity  to  be  sent  long 
distances  at  high  tension  with  a  comparatively  small  expen- 
diture for  copper  wire,  bringing  into  profitable  operation  a 
large  number  of  water  powers  which,  until  recently,  were 
wasted;  and  we  have  the  use  of  the  gas  engine  which  is 
now  being  built  in  very  large  units.  New  inventions  are  also 
succeeding.  The  Thermos  bottle,  for  example,  supplies  a 
definite  want,  and  within  one  year  it  is  reported  that  more 
than  700,000  of  these  were  sold  at  high  prices.  In  the  de- 
partment of  building  operation,  the  growing  use  of  concrete 
for  dwelling  houses  promises  to  revolutionize  the  industry. 
Everywhere,  improvements,  long  since  discovered,  are  now 
forcing  themselves  into  general  notice  and  use,  and  new  im- 
provements are  attracting  instant  attention.  Never  before 
in  the  world's  industrial  history  has  man  increased  his  con- 
quest over  nature  at  such  a  rapid  rate  and  simultaneously  in 
so  many  fields. 

These  opportunities  for  the  production  of  wealth  are  op- 
portunities for  the  investment  of  money,  for  the  investment 
of  money  aids,  either  directly  or  indirectly,  in  the  production 
of   wealth.     The   investor  buys  $50,000   of   railway  bonds. 


INTRODUCTION  3 

With  the  proceeds  the  railroad  replaces  a  wooden  trestle  with 
a  steel  bridge.  Over  this  bridge  it  can  run  a  heavier  train 
load,  which  it  obtains  by  the  lower  rate  which  the  decrease 
in  operating  cost  resulting  from  the  heavier  train  load  makes 
possible.  The  lower  rate  enables  the  farmer  to  turn  a  part 
of  his  grazing  land  into  wheat,  and  so  eventually  the  $50,000 
invested  in  the  railway  bonds  has  increased  the  supply  of 
wheat  on  the  world's  market.  This  increased  production  of 
wealth  was  made  possible  by  the  purchase  of  the  bonds  which 
the  investor  bought  because,  out  of  their  increased  earnings, 
the  railroad  could  pay  him  four  per  cent  interest.  Without 
investment  increased  production  would  be  impossible.  Upon 
the  investor  rests  the  responsibility  of  adding  to  the  wealth 
of  the  world.  As  he  directs  his  funds  to  railroads,  cotton 
mills,  irrigation,  or  shipbuilding,  the  productive  energy  of 

.^^  society  is  exerted  in  this  or  that  field  of  enterprise. 

"31  This  office  of  investment  is  variously  performed.  Men 
may  invest  or  capitalize  their  own  savings.  The  farmer 
devotes  one  thousand  dollars,  half  the  proceeds  of  his  last 
wheat  crop,  to  the  purchase  of  nitrate  fertilizer.  The  New 
England  cotton  manufacturer  invests  his  surplus  earnings 
in  a  South  Carolina  mill  where  cheap  power,  labor,  and  ma- 
terial invite  development.  The  Bessemer  steel  maker  adds 
an  open  hearth  furnace  to  his  equipment,  and  takes  advantage 
of  a  local  supply  of  scrap.  The  Pennsylvania  coal  operator 
or  lumberman  buys  the  cheap  coal  and  timber  land  of  the 
South.  Every  successful  producer  is  continually  devoting 
his  surplus  funds  to  enlarge  his  enterprise  along  lines  with 
which  he  is  familiar  as  competition  compels  or  as  opportunity 
presents  for  greater  profits.  The  producer  often  branches 
out  into  other  fields,  as  when  the  farmers  of  a  locality  erect 
a  flour  mill  or  a  sawmill,  or  open  a  stone  quarry,  or  a  car- 

,  riage  maker  engages  in  the  manufacture  of  automobiles,  or 
a  railroad  spends  a  portion  of  its  surplus  in  purchasing  a 
coal  property  on  its  line.  By  such  investments  producers 
extend  their  business  out  of  their  profits  and  with  their  own 
funds. 


4  COKPORATION  FINANCE 

Every  industry  is  constantly  growing  from  within — as 
the  biologists  say,  by  intussusception — out  of  the  profits  of 
the  past,  and  individual  producers  are  making  ventures  of 
their  money  into  untried  fields  in  enterprises  where  they 
alone  stand  to  win  or  to  lose,  and  where  they  act  from  per- 
sonal knowledge  of  the  opportunity. 

There  is  a  second  class  of  investors  which  may  include 
some  of  the  first  class  but  whose  members  are  actuated  by 
different  motives  and  who  act  in  a  different  way.  These 
persons  are  also  in  possession  of  surplus  funds  from  the  em- 
ployment of  which  they  wish  to  obtain  a  profit,  and  they  are 
ready  to  buy  the  stock  of  any  corporation  which  gives  them 
the  assurance  of  satisfactory  returns.  They  are  in  the  market 
for  any  securities  which  they  consider  to  be  safe  and  profit- 
able investments.  The  members  of  this  class  are  not,  as  a 
rule,  in  close  touch  with  the  industries  whose  securities  they 
buy.  A  leather  merchant  invests  in  steel,  a  banker  in  rail- 
roads, a  retail  dealer  in  mining  stock,  not  because  he  desires 
to  identify  himself  with  the  business  in  which  he  invests, 
so  far  as  to  give  it  his  close  personal  attention  and  to  assist 
in  its  management,  but  solely  that  he  may  share  in  its  profits. 
Included  in  this  class  are  investment  institutions  and  man- 
agers of  trust  funds,  who  take  no  active  part  in  the  numer- 
ous enterprises  whose  securities  they  hold  and  who  may  know, 
indeed,  little  or  nothing  about  the  business. 

The  importance  of  this  vicarious  interest  in  industry  is 
steadily  increasing.  Production  is  each  year  being  carried 
on  on  a  larger  scale,  and  it  becomes  increasingly  difficult  for 
a  few  men  to  combine  a  sufficient  amount  of  capital  for 
the  inauguration  of  a  new  enterprise  or  the  development  of 
an  enterprise  already  established.  Twenty  years  ago  a  few 
thousand  dollars  would  build  a  sawmill.  A  half  dozen 
farmers,  by  combining  their  savings,  could  start  in  the 
lumber  business.  To-day  a  well-equipped  sawmill  may  cost 
$100,000,  and  added  to  this  may  be  the  expense  of  per- 
haps twenty  miles  of  railroad  to  reach  the  timber.'  The 
assistance  of  outside  capital  is  becoming  every  year  more 


J 


INTRODUCTION  5 

essential  to  the  development  of  any  industry  or  the  exploita- 
tion of  any  resource. 

A  very  good  example  is  the  Pennsylvania  Tunnel  Ex- 
tension under  Manhattan  Island  connecting  New  Jersey  with 
Long  Island.  The  primary  object  of  this  tunnel  is  to  bring 
Long  Island  into  direct  touch  with  the  congested  district  of 
Manhattan.  The  plan  is  this:  The  Pennsylvania  Railroad 
Company  owns  a  majority  of  the  stock  of  the  Long  Island 
Railroad  Company  which  completely  dominates  Long  Island. 
Long  Island  is  largely  vacant  territory.  If  Long  Island  can 
be  brought  into  direct  contact  with  Manhattan,  a  large 
number  of  people  will  move  from  Manhattan  into  Long 
Island,  they  will  increase  the  population  of  the  towns  of 
Long  Island,  manufacturing  enterprises  will  spring  up  along 
the  lines  of  the  Long  Island  Railroad,  and  a  dense  popula- 
tion will  at  no  distant  date  be  settled  in  the  eastern  end  of 
the  Island.  The  Long  Island  Railroad  will  supply  the  means 
of  'transportation  to  this  population,  and  the  Pennsylvania 
will  profit  from  the  dividends  on  its  interest  in  the  Long 
Island  Railroad  Company,  and  also  because  to  the  Penn- 
sylvania will  come  the  transportation  of  most  of  the  freight 
which  that  large  population  will  use.  Then  there  is  some 
advantage,  though  very  slight,  from  the  passenger  traflSc 
west-bound  from  Long  Island,  and  also  a  certain  advertising 
value  connected  with  the  building  of  a  beautiful  terminal  in 
the  center  of  Manhattan.  This  is  a  very  large  enterprise. 
While  its  outlines  are  clear  and  its  success  is  assured,  it 
could  not  be  carried  through  out  of  the  profits  of  the  Penn- 
sylvania Railroad.  For  the  completion  of  the  work  which 
will  cost  over  one  hundred  million  dollars,  the  Pennsylvania 
Railroad  Company  has  raised  a  large  amount  of  money 
through  the  sale  of  stocks  and  bonds.  In  order  to  get  money 
together  for  large  undertakings  of  this  character,  it  is  neces- 
sary to  draw  upon  the  funds  of  a  large  number  of  investors, 
and  especially  upon  financial  institutions:  trust  companies, 
insurance  companies  and  savings  banks,  which  are  great  reser- 
voirs of  investment  funds. 
2 


6  COEPOKATION  FINANCE 

The  investor  is  appealed  to  to  furnish  funds  for  two 
classes  of  enterprises:  those  which  are  already  in  existence, 
and  new  enterprises  which  are  to  come  into  existence  through 
the  money  he  advances.  The  investor  will  not  look  up  new 
schemes  of  investment  for  himself.  He  will,  however,  buy 
securities  which  are  offered  to  him  when  they  are  properly  pre- 
sented to  him,  for  the  purpose  of  increasing  his  interest  on  his 
capital.  The  proprietors  of  this  outside  capital  know  little 
about  the  technical  aspects  of  the  industries  into  which  they 
put  their  money.  They  are  acquainted  with  these  industries 
merely  as  sources  of  profit.  If  they  can  be  given  satisfactory 
assurances  that  profits  will  be  forthcoming  from  a  proposed 
development,  they  are  willing  to  invest  money  to  that  end. 
They  will  not,  however,  devote  themselves  to  searching  out 
and  preparing  the  propositions  into  which,  when  once  dis- 
covered and  prepared,  they  are  willing  to  put  their  money. 

This  attitude  of  the  general  investor  brings  forward  the 
promoter  whose  function  in  industry  is  that  of  discovering 
investment  opportunities,  forming  companies  to  develop  these 
opportunities,  and  selling  the  securities  of  those  companies  to 
obtain  funds  for  development.  The  function  of  promotion 
involves  three  stages:  first,  the  discovery  of  the  proposition; 
second,  the  assembling  of  the  proposition  and  third,  the 
presentation  of  the  proposition. 

The  work  of  the  promoter  may  be  explained  by  describ- 
ing the  promotion  of  two  enterprises:  a  small  coal  company 
in  Western  Pennsylvania,  and  the  industrial  combinations, 
commonly  known  as  "  trusts,"  which  have  now  absorbed  a 
large  portion  of  our  productive  industry. 

Western  Pennsylvania  is  underlaid  with  great  sheets  of 
bit 'ominous  coal.  It  contains  one  of  the  most  important  fuel 
reserves  of  the  United  States.  The  coal  is  generally  of  good 
quality,  and  it  is  accessible  to  the  largest  markets  in  the 
country.  A  large  number  of  mining  propositions,  most  of 
which  have,  since  their  inauguration,  been  consolidated  under 
the  ownership  of  a  few  corporations,  have  been  developed  in 
this  region.     The  law  gives  the  owner  of  land  the  right  to 


INTRODUCTION  7 

all  the  minerals  which  may  be  fouifd  beneath  its  surface. 
The  land  under  which  this  coal  lies  i&  poor  farming  land, 
situated  usually  in  narrow  valleys  intersected  by  streams 
which  have  excavated  deep  channels  offering  easy  access  to 
coal  seams  whose  outcroppings  are  exposed  on  the  banks  and 
hillsides.  This  land  is  owned  in  tracts  varying  from  ten 
acres  up  to  three  hundred  acres.  Many  of  the  farmers  mine 
coal  for  their  own  use  and  for  local  sale.  A  large  number  of 
^'  country  banks  "  are  found  where,  with  primitive  appliances, 
a  considerable  amount  of  coal  is  extracted.  The  sale  of  this 
coal  is  restricted  to  the  immediate  neighborhood  since,  in 
the  absence  of  a  large  mining  development,  railway  facilities 
would  not  be  provided. 

Such  a  region  may  attract  the  attention  of  bankers  or  cap- 
italists who  are  interested  in  the  development  of  coal  prop- 
erties, and  they  will  organize  a  syndicate  for  its  development. 
The  syndicate  will  be  organized,  in  much  the  same  manner 
as  a  partnership  association,  under  the  terms  of  a  syndicate 
agreement,  whereby  the  subscribers  associate  themselves  into 
an  organization  which  it  is  agreed  shall  be  managed  by  one 
or  more  of  their  number  known  as  "  Syndicate  Managers," 
and  agree  to  pay  into  a  common  fund  a  certain  amount  of 
money  to  be  used  in  the  development  of  a  certain  enter- 
prise. Some  part  of  this  money  may  be  borrowed  by  the 
syndicate;  a  larger  amount  is  usually  borrowed  by  the  mem- 
bers. We  shall,  in  a  later  chapter,  consider  the  organization 
and  administration  of  syndicates  in  detail;  for  our  present 
purpose,  this  brief  description  will  suffice.  The  syndicate 
having  been  organized,  a  call  is  made  upon  the  members  for 
a  small  percentage  of  their  subscriptions  for  preliminary 
expenses.    The  syndicate  is  now  ready  for  operation. 

Some  of  their  number  will  have  received  a  considerable 
amount  of  information  concerning  the  possibilities  of  the 
coal  mining  development  under  consideration,  either  from 
a  local  promoter  or  from  some  other  source.  The  local 
promoter  is  usually  a  small  lawyer  or  rural  capitalist  whose 
ambition  outruns  his  means,  and  who  may  have  spent  some 


8  COKPORATION   FINANCE 

money  in  preliminary  surveys  and  examinations,  the  re- 
sults of  which  are  communicated  to  some  banker  or  min- 
ing official  who  has  command  of  the  necessary  capital,  and 
who  can,  with  his  associates,  develop  the  possibilities  of 
the  proposition.  At  this  point,  the  promoter,  usually  so- 
called,  namely  the  local  man  who  has  introduced  the  proposi- 
tion to  the  capitalist,  passes  out  of  the  narrative.  He  may 
be  paid  a  certain  amount  of  cash  for  the  work  he  has  done, 
or  may  be  allotted  a  small  interest  in  the  syndicate,  which 
secures  him  in  the  possession  of  a  small  amount  of  the  stock 
which  the  company  to  be  organized  may  issue.  He  is  not 
apt  to  be  a  very  important  factor  in  the  future  development 
of  the  proposition. 

Starting  with  this  preliminary  information,  the  syndicate 
now  has  a  thorough  examination  made  of  the  property  which 
they  propose  to  develop.  Engineers  are  sent  into  the  field  to 
furnish  the  necessary  technical  information  upon  which  the 
proposition  must  be  based.  From  the  reports  of  these  en- 
gineers, it  will  be  determined  whether  the  coal  seam  is  reg- 
ular, or  faulted  and  broken,  requiring  a  large  amount  of 
expensive  rock  excavation  for  large  development,  also  if  the 
proposed  mining  operation  will  be  self -draining,  or  if  pump- 
ing machinery  must  be  installed;  the  percentage  of  sulphur 
and  silicon  which  the  coal  contains,  its  properties  as  a  coking 
coal  out  of  which  a  coke  can  be  made  which  will  stand  up 
under  heavy  burdens  in  the  blast  furnace.  Surveys  will  also 
be  made  of  the  proposed  railroad  without  which  commercial 
coal  production  is  impossible.  The  cost  of  mining  develop- 
ment and  of  railway  construction  will  be  determined  as 
accurately  as  possible.  At  a  cost  of  perhaps  $5,000,  the  syn- 
dicate can  gain  approximately  exact  information  concerning 
the  physical  features  of  the  proposition. 

In  addition  to  the  information  received  from  technical 
experts,  although  engineers  usually  assume  to  work  in  this 
field  also,  the  financial  aspect  of  the  proposition  is  carefully 
considered.  In  a  thorough  investigation  of  a  coal  mining 
proposition,  the  price  per  acre  at  which  the  land  can  be 


INTKODUCTION  9 

purchased,  the  rate  of  freight  charged  by  the  connecting 
railroads,  and  the  prices  which  can  be  obtained  for  this  grade 
of  coal  in  the  different  markets  must  be  determined.  Other 
considerations  to  be  taken  account  of  include  the  labor  situa- 
tion of  the  region,  especially  the  strength  of  labor  organiza- 
tions, the  laws  of  the  State  regulating  the  company  store; 
and  the  attitude  of  the  railroads  toward  a  new  mining  enter- 
prise— whether  they  will  be  helpful  or  indifferent. 

After  all  this  data  has  been  gathered  and  collated,  a  de- 
cision may  be  reached  to  go  forward,  or  the  proposition  may 
be  abandoned  because  of  the  disclosure  of  unfavorable  factors 
not  revealed  by  the  preliminary  investigation  on  the  basis  of 
which  the  syndicate  was  organized.  This  initial  investigation 
of  a  proposition,  the  disclosure  of  all  the  factors,  favorable 
and  unfavorable,  affecting  its  ultimate  success,  must  be  thor- 
oughly carried  through  or  the  enterprise  is  doomed  to  failure. 

The  countless  disappointments  in  the  development  of  new 
enterprises  of  all  kinds  are  due,  not  so  much  to  abuses  of 
management  or  mistakes  in  capitalization,  as  to  imperfect 
investigation  reaching  wrong  conclusions  as  to  business  pos- 
sibilities. So-called  investigations  made  by  local  promoters 
are  in  most  cases  worthless.  Their  interests  are  so  deeply 
involved  in  putting  the  best  face  possible  on  a  scheme  that 
both  their  observations  and  their  deductions  are  of  little 
value.  Even  the  investigations  of  so-called  "  experts "  are 
open  to  serious  question.  The  expert's  views  are  also  col- 
ored by  his  interests  since  he  is  often,  apparently,  employed 
not  so  much  to  keep  his  principal  out  of  an  investment  as 
to  confirm  his  principal's  Judgment  that  the  enterprise  will 
be  successful. 

There  is  in  the  neighborhood  of  a  large  Eastern  city  a 
suburban  railroad  running  out  about  twelve  miles  from  a 
terminal  station  at  the  end  of  a  city  transportation  line 
through  a  number  of  fashionable  suburban  towns,  paralleling 
throughout  its  entire  distance  the  main  line  of  a  large  and 
well  managed  steam  railway  company.  The  fate  of  the  com- 
pany  which   constructed   this   line    furnishes    an   excellent 


10  COKPORATION   FINANCE 

illustration  of  the  blunders  into  which  supposedly  compe- 
tent investigators  are  likely  to  fall  in  examining  a  business 
proposition.  The  syndicate  which  promoted  this  enterprise 
and  which  completed  it  with  its  own  money,  no  securities 
being  offered  to  the  public,  employed  engineers  of  high  repu- 
tation to  examine  into  the  cost  and  traffic  of  the  enterprise. 
The  line  was  accurately  surveyed,  estimates  were  made  of 
the  cost  of  obtaining  ground  for  a  private  right  of  way,  and 
options  were  secured  on  a  large  amount  of  real  estate  for  the 
development  of  suburban  towns. 

The  engineers  also  addressed  themselves  to  the  possibilities 
of  traffic  for  the  new  line  based  on  the  population  then  in 
existence.  The  experience  of  interurban  railroads  in  the  West, 
where  the  experience  of  these  experts  had  been  gained,  has  been 
that  a  high-speed  interurban  line  divides  traffic  with  the  steam 
line.  It  is  usually  assumed  that,  from  an  estimate  of  the 
traffic  on  the  steam  line,  it  will  be  possible  to  approximate 
the  number  of  passengers  which  will  be  drawn  away  to  the 
electric  road.  The  engineers  in  this  case  followed  this 
method.  They  made  careful  computations  of  the  traffic  at 
each  one  of  the  stations  on  the  line  of  railroad  which  their 
line  was  to  parallel,  and  on  the  basis  of  this  traffic  they  made 
an  estimate  of  the  traffic  to  be  gained  by  the  suburban  line. 
Their  estimates  were  accepted  and  the  line  was  built,  about 
three  and  a  half  million  dollars  being  provided  by  the 
syndicate. 

No  sooner  was  the  new  line  put  into  operation  than  it 
was  discovered  that  the  engineers  had  made  serious  blunders 
in  their  calculations.  The  people  of  the  towns  through  which 
the  new  line  ran  were  entirely  satisfied  with  the  service  fur- 
nished them  by  the  steam  line  which  landed  them  in  the 
heart  of  the  city.  The  new  suburban  line,  on  the  other  hand, 
would  only  give  them  a  connection  with  a  city  line,  neces- 
sitating a  change  of  cars  at  considerable  inconvenience.  The 
class  of  people  who  were  expected  to  patronize  the  new  road 
are  well-to-do.  To  them,  the  advantages  of  saving  a  few  cents 
in  fare,  and  the  more  frequent  service  offered  by  the  electric 


4^ 

INTRODUCTION  11 

line  were  of  no  consequence.  The  traffic  of  the  new  road 
proved  a  sore  disappointment  to  its  promoters.  It  failed  from 
the  beginning  to  pay  its  fixed  charges,  and  for  a  time  even  its 
operating  expenses  were  not  earned.  In  1908  its  net  deficit 
was  $176,194.  It  has  since  been  sold  at  less  than  one  third  of 
the  amount  of  money  invested  in  its  construction ;  an  expen- 
sive extension  must  be  built  to  make  it  profitable;  and  it 
stands  as  a  monumental  blunder  of  supposed  experts. 

The  difficulty  in  obtaining  accurate  information  concern- 
ing the  merits  of  the  propositions  which  are  brought  to  the 
attention  and  which  arouse  the  interest  of  active  men  of 
affairs,  has  led  to  the  development  of  a  new  type  of  promoter 
whom  we  will  call,  for  lack  of  a  better  term,  the  promoting 
engineer.  The  promoting  engineer  is  a  firm  or  corporation 
engaged  in  the  business  of  building  trolley  roads,  power 
plants,  railroads;  doing  all  kinds  of  engineering  and  con- 
struction work  within  a  certain  field.  They  have  a  certain 
capital — the  capital  of  some  engineering  firms  runs  into  the 
millions — and  they  can  borrow  several  times  tlie  amount  from 
banks.  They  build  up  a  permanent  organization  of  engineers, 
chemists,  accountants,  and,  in  some  cases,  lawyers. 

The  engineering  concern  wishes  to  keep  its  organization 
constantly  employed.  Among  its  clients  are  bankers  and  cap- 
italists who  seek  their  advice  on  the  merits  of  propositions. 
If  their  opinion  is  favorable,  they  are  likely  to  obtain  the 
engineering  work.  Usually,  in  such  a  case,  they  include  the 
fee  for  investigation  in  their  engineering  commission.  As  a 
result  of  these  inquiries  and  employments,  the  engineering 
concern  in  time  advances  to  the  investigation  and  presenta- 
tion of  propositions  of  their  own.  They  have  no  lack  of 
opportunities  for  independent  effort  of  this  kind.  Large 
numbers  of  propositions  are  thrust  upon  them  from  which 
they  can  choose  those  which  seem  promising.  If,  after  a 
preliminary  investigation  of  a  project,  the  engineers  con- 
sider it  worth  undertaking,  they  secure  the  necessary  options, 
and  present  the  scheme  to  bankers  and  capitalists  with  whom 
they  are  connected. 


I 


12  CORPOKATION   FINANCE 

A  proposition  submitted  by  an  engineering  concern  of 
repute  and  authority  in  their  chosen  field  will  receive  re- 
spectful attention  from  the  banker  who  recognizes  that  the 
engineer's  interest  is  not  primarily  to  take  part  in  the  pro- 
motion, but  to  secure  employment  for  himself  and  his  organ- 
ization, and  to  make  his  regular  engineering  profits.  The 
engineer  may  also,  in  order  finally  to  convince  the  banker, 
take  part  in  the  financing  of  the  enterprise.  He  may  acquire 
an  interest  in  the  syndicate  which  he  proposes  should  be 
organized  for  its  development.  This  interest  the  engineer 
will  dispose  of,  should  opportunity  offer,  even  if  he  has  to  sell 
it  at  cost,  either  to  the  members  of  the  syndicate,  or  to 
outside  interests  with  the  consent  of  the  members  of  the 
syndicate.  The  engineer  is  not  in  the  banking  business,  save 
incidentally  and  to  obtain  new  business  for  himself.  A 
usual  condition  of  his  participation  in  the  flotation  is  that 
he  should  be  given  the  supervision  of  the  construction.  The 
engineer  may  go  a  step  farther  and  supervise  the  operations 
of  the  electric  railway  or  gas  plant  during  its  initial  stages. 
He  assumes  these  duties,  as  a  rule,  with  the  cordial  approval 
of  the  bankers.  They  are  glad  to  secure,  in  this  manner,  an 
assurance  of  responsibility  and  competent  management  which 
the  engineer  is  qualified  to  furnish. 

The  promoting  engineer  possesses  advantages  over  any 
other  kind  of  investigator,  from  the  standpoint  of  the  banker 
who  advances  the  funds  to  make  new  enterprises  possible,  in 
that  the  engineer's  interest  is  on  the  side  of  thorough  investi- 
gation, economical  construction,  and  careful  management. 
Especially  when  the  engineer  shares  the  risks  of  the  under- 
taking, is  the  banker  glad  to  defer  to  his  judgment  and  to 
invest  money  in  the  projects  which  the  engineer  indorses. 
There  are  a  large  number  of  engineering  concerns  of  this 
character  in  the  United  States.  One  of  the  largest,  the 
Stone  &  Webster  Corporation  of  Boston,  has  gone  so  far  as 
to  develop  a  banking  department  in  connection  with  its 
engineering  work,  through  which  it  sells  the  securities  of  its 
own  enterprises.    The  importance  of  thorough  investigation 


INTRODUCTION  13 

is  now  so  generally  recognized  that  alliances  of  this  char- 
acter between  engineers  and  bankers  may  be  expected  to  be- 
come general.  They  are  usually  found  more  satisfactory 
than  when  the  engineer  is  employed  by  the  banker  in  an 
expert  capacity. 


CHAPTER   II 

THE  WORK  OF  THE  PROMOTER 

After  the  investigation  is  completed,  if  it  is  decided  to 
proceed,  the  next  step  is  to  assemble  the  proposition.  By 
assembling  is  meant  the  securing  of  control  of  the  property 
or  rights  upon  which  the  proposition  must  be  based.  There 
are  two  methods  of  getting  a  property  under  control.  The 
first  is  to  buy  it  and  the  second  is  to  buy  the  right  to  buy 
it,  in  other  words,  to  secure  an  option  upon  it.  Outright 
purchase  is  for  the  promoter  usually  impossible,  especially  in 
the  case  of  new  enterprises  which  are  to  be  financed  by  the 
Bale  of  securities  to  investors.  The  money  to  develop  the 
enterprise  must  first  be  obtained  from  bankers  who  will 
reimburse  themselves  by  selling  the  securities  to  their  cus- 
tomers. Bankers  will  not  undertake  to  advance  large  amounts 
of  money  for  the  development  of  a  scheme  until  there  is  a 
definite  proposition  put  before  them.  They  will  not,  for 
example,  set  aside  $1,000,000  of  their  funds  to  develop  a 
water  power  proposition  until  all  the  lands  adjacent  to  the 
water  power,  and  which  are  necessary  for  its  development, 
have  been  secured.  A  part  of  this  money  the  bankers  may 
have  to  borrow.  They  will  not  undertake  these  responsibil- 
ities merely  to  encourage  the  promoters  to  make  an  earnest 
effort  to  get  the  proposition  together.  The  promoters  must 
give  them  definite  assurances  that  all  the  property  necessary 
is  under  their  control  before  the  bankers  will  tell  them 
whether  they  are  prepared  to  advance  the  necessary  funds. 
As  for  the  promoters  themselves  to  purchase  the  property, 
even  if  they  have  the  money,  they  cannot  afford  to  risk  it  in 
14 


THE   WORK   OF   THE   PROMOTER  15 

the  purchase  of  resources  whose  development  they  may  not  be 
able  to  finance. 

For  example,  in  the  coal  land  proposition  which  we  have 
considered,  to  buy  the  5,000  acres  which  is  necessary,  at  $20 
an  acre,  would  require  $100,000.     Suppose  this  initial  outlay 
to  be  made,  and  that  the  promoters  find  that,  owing  to  the 
adverse  conditions  of  the  money  market,  or  to  some  hitherto 
undiscovered  imperfection  in  the  project,  bankers  refuse  to 
advance  the  necessary  funds.    They  have  $100,000  locked  up 
in  undeveloped  property,  which  represents  $6,000  a  year  in        W 
interest,  a  large  part  of  which  may  have  been  borrowed,  and  '  • 
they  may  be  seriously  embarrassed  before  they  succeed,  \V  ^^ 
indeed   they    ever    succe^,    in    securing   the   funds    for   its  XA^ 
development.     Outright  purchase  of  properties  for  the  devel- 
opment of  business  propositions  is  not  merely  undesirable 
but  unnecessary.    The  same  result  as  purchase,  so  far  as  the 
promoters  are  concerned,  can  be  reached  by  buying  the  right 
to  purchase,  in  other  words,  by  obtaining  an  option  on  the 
property  which  they  desire. 

An  option  is  a  privilege  existing  in  one  person,  for  which 
he  has  paid,  giving  him  the  right  to  buy  certain  realty, 
merchandise,  or  securities  from  another  person  within  a  cer- 
tain time  at  a  fixed  price,  or  to  sell  such  property  to  such 
other  person  at  an  agreed  price  or  time.  An  option  is,  there- 
fore, an  unaccepted  offer  which  runs  for  a  definite  time.  It 
states  the  terms  and  conditions  on  which  the  owner  is  willing 
to  sell  or  lease  his  property  if  the  offeree  elects  to  accept 
them  within  the  time  named  in  the  Option.  If  the  holder 
of  the  option,  known  as  the  optionee,  elects  to  accept  the 
offer  of  the  optionor,  he  must  give  notice  to  the  optionor 
and  the  accepted  offer  thereupon  becomes  a  binding  contract. 
If  an  acceptance  is  not  given  within  the  time  specified,  the 
owner  is  no  longer  bound  by  his  offer  and  the  option  is  at 
an  end.  In  effect,  a  man  who  grants  an  option  on  his  prop- 
erty binds  himself  to  make  a  contract  to  sell  that  property 
at  a  future  time  and  to  convey  a  good  title.  An  option  con- 
tract, like  any  other  contract,  is  based  upon  a  consideration. 


16  CORPOEATION   FINANCE 

This  may  be  small;  one  dollar  is  a  binding  consideration. 
It  is  usual,  if  a  substantial  payment  is  made,  to  apply  this 
on  the  purchase  price  if  the  offer  of  the  optionor  is  eventually 
accepted. 

The  rights  of  the  optionee  in  the  property  are  those 
expressly  named  in  the  contract  of  option,  and  those  which 
are  implied  from  the  terms  of  the  contract.  It  is  usual  to 
give  the  optionee  some  right  to  enter  upon  and  examine  and 
sometimes  even  to  take  temporary  charge  of  the  property 
which  he  proposes  to  purchase.  For  example,  in  1905,  the 
Southern  Railway  Company  and  the  Illinois  Central  Railway 
Company  entered  into  a  contract  by  which  they  purchased 
the  prior  lien  bonds  of  the  Tenne«see  Central  and  obtained 
options  for  three  years  upon  the  general  mortgage  bonds  of 
the  Tennessee  Central,  the  bonds  of  the  National  Terminal 
Company  and  practically  all  the  capital  stock  of  this  com- 
pany except  that  held  by  counties  and  municipalities.  Pend- 
ing the  acceptance  or  surrender  of  the  option,  they  paid 
interest  on  the  securities  and  operated  the  company  under 
an  agreement  to  keep  it  free  from  debt.  The  option  expired 
July  1,  1908.  The  operation  of  the  property  had  not  been 
profitable,  and  the  railroads  surrendered  their  rights. 

A  privilege  commonly  given  to  the  optionee,  in  the  case 
of  purchase  of  a  going  concern,  is  to  have  an  exhaustive  audit 
made  of  the  books  of  the  company  to  determine  its  profits 
for  a  term  of  years.  For  the  protection  of  "the  optionee,  it 
may  be  provided  that  the  owner  of  the  property  shall  do 
nothing  which  might  impair  its  value,  for  example,  that  he 
must  keep  up  the  insurance,  discharge  all  taxes,  interest  and 
mechanics  lien  obligations,  and,  in  general,  maintain  the 
property  in  the  condition  which  would  render  it  available 
for  the  uses  to  which  the  optionee  intends  to  put  it  in  case 
he  decides  to  exercise  his  rights  under  the  option. 

A  valuable  right  connected  with  an  option  contract,  from 
the  standpoint  of  the  optionee,  is  the  right  to  assign  the 
option.  This  is  not  implied  but  must  be  set  forth  in  the 
option  contract.     If  the  right  to  assign  exists,  then  the  pro- 


THE   WOKK   OF   THE   PKOMOTER  17 

moter  is  in  a  position  to  deal  to  advantage  with  the  proposed 
corporation.  He  can*  either  obtain  from  the  company  the 
funds  with  which  to  purchase  the  property  which  he  has 
under  option,  afterwards  transferring  it  to  the  company  in 
return  for  his  agreed  compensation,  or  he  can  assign  his 
rights  under  the  option  contract  to  the  company  which  can 
then  take  them  up  direct. 

The  remedy  of  the  optionee,  in  case  the  optionor  refuses 
to  carry  out  his  agreement  to  sell  the  property,  on  being 
notified  by  the  optionee  that  he  is  prepared  to  take  it,  and 
after  the  purchase  price  has  been  tendered,  varies  according 
to  the  ownership  of  the  property  at  the  time.  When  the 
property  remains  in  the  possession  of  the  optionor^  the  op- 
tionee's remedy  is  to  go  into  a  court  of  equity  and  ask  for 
a  bill  of  specific  performance  which  the  court,  on  proper 
showing  being  made,  will  issue,  requiring  the  optionor  to 
transfer  the  property.  When  the  property  has  passed  into 
the  hands  of  an  innocent  third  party,  however,  the  only 
remedy  of  the  optionee  is  a  suit  for  damages.  The  measure 
of  the  damages  may  be  the  margin  between  the  price  named 
in  the  option  and  the  present  market  value  of  the  property. 
It  is  easy,  however,  to  block  such  conversions  by  recording 
the  option  at  the  time  it  is  created.  The  purchaser  of  the 
property  is  then  chargeable  with  notice  that  certain  rights 
against  this  property  have  been  created  in  the  option  con- 
tract, and  he  takes  it  subject  to  a  liability  to  have  a  bill 
for  specific  performance  issued  against  him.  The  form  of 
the  option  contract  conforms  with  the  requirements  of  any 
contract  as  to  form  and  consideration;  capacity  of  parties; 
and  legality  of  object. 

Having  decided  to  option  5,000  acres  of  coal  land  owned 
by  perhaps  one  hundred  farmers,  the  syndicate  sends  an  agent 
into  the  district,  and  visits  these  farmers  at  their  homes.  He 
explains  his  purpose  to  them,  assures  them  that  he  will  be 
able  to  raise  the  money  to  develop  his  proposition,  and  asks 
them,  for  the  sake  of  their  mutual  interest,  and  for  a  nominal 
consideration  in  hand  paid,  to  sell  him  an  option  to  purchase 


18  COKPOKATION  FINANCE 

their  property  at  any  time  within  six  months,  at  a  price  of, 
say,  $20  per  acre. 

Various  arguments  may  be  employed  to  influence  a  gen- 
eral assent  to  this  proposition.  The  landowners  may  be 
shown  that  the  value  of  the  surface  soil,  which  will  remain 
in  their  possession  after  the  transfer  of  the  coal,  will  be  in- 
creased by  the  demands  which  a  coal  mining  community  will 
make  for  the  produce  of  their  farms.  They  may  be  offered 
the  advantage  of  a  railway  which  the  opening  of  coal  mines 
will  bring.  The  hopelessness  of  developing  their  own  prop- 
erty may  be  pointed  out  to  them,  and,  as  a  last  resort,  the 
promoter  may  threaten  to  "  sew  them  up  "  by  refusing  to 
transport  their  coal  over  his  road.  By  employing  such  argu- 
ments, the  promoter  persuades  the  farmers  to  option  or 
"  lease  '^  their  land. 

As  far  as  possible,  he  keeps  each  owner  in  ignorance  of 
the  terms  offered  to  his  neighbors,  for  a  general  diifusion 
of  such  information  would  cause  a  general  raising  of  prices. 
In  dealing  with  the  well-to-do  and  intelligent  farmers,  he 
must  often  pay  a  high  price  for  the  option,  and  the  price 
named  in  th^ir  instrument  is  also  high.  The  promoter  sub- 
mits to  these  onerous  terms  not  merely  because  he  wants  the 
land  of  these  hard  bargainers  who  know  just  how  indispens- 
able their  coal  is  to  him,  but  also,  and  chiefly,  because  he 
desires  to  use  their  names  and  influence  with  other  owners. 
These  higher  prices  are  recovered  in  dealing  with  the  more 
ignorant  landowners,  who  are  greatly  impressed  with  the 
representations  of  the  promoter,  and  also  by  the  fact  that 
their  richer  neighbors  have  joined  the  scheme.  It  may  even 
be  necessary  for  the  promoter  to  employ  coercion  through  an 
alliance  with  the  general  storekeeper  who  may  hold  chattel 
mortgages  and  judgment  notes  against  the  recalcitrants — 
powerful  arguments  when  skillfully  employed. 

The  proposition  has  now  been  assembled ;  the  owners  have 
obligated  themselves  to  sell  to  the  syndicate  at  a  certain 
price  until  the  expiration  of  the  period  named  in  the  option. 
It  is  known  how  much  the  land  and  development  will  cost 


4 


THE   WOKK   OF   THE   PEOMOTER  19 

and  the  land  is  under  the  syndicate's  control.  The  next  step 
is  to  finance  the  enterprise.  At  this  point,  a  corporation 
is  usually  formed  to  take  over  the  options.  The  bonds  or 
stock  of  this  corporation  are  taken  by  the  syndicate  whose 
members  are  now  called  upon  to  pay  a  substantial  portion 
of  their  subscriptions.  A  portion  of  the  necessary  funds  may 
also  be  borrowed,  the  securities  being  deposited  as  collateral 
for  loans.  With  the  money  raised  in  this  manner,  the  cor- 
poration, all  of  whose  stock  is  owned  by  the  syndicate,  pur- 
chases the  coal  land,  makes  the  development  necessary,  and 
starts  the  company  as  a  going  concern.  After  a  record  of 
earnings  has  been  established,  the  securities  of  the  company 
are  usually  offered  for  sale.  If  the  enterprise  has  been  wisely 
planned  and  economically  developed,  these  securities  may  be 
sold  at  prices  which  will  restore  the  syndicate's  original  in- 
vestment, and  either  leave  them  in  control  of  the  stock  of 
the  company  or  enable  them  to  sell  out  all  their  holdings 
of  its  securities  at  a  profit. 

This  represents  a  typical  promotion.  Similar  enterprises 
are  constantly  being  promoted  throughout  the  country,  not 
only  on  mines,  but  on  real  estate,  manufacturing  enterprises, 
railroads,  water  powers,  irrigation  and  timber  projects.  The 
details  of  each  may  vary  from  the  form  presented,  but  the 
essential  principles  are  the  same:  (1)  The  securing  of  a  right 
to  purchase  an  opportunity  to  make  money;  (2)  the  capital- 
ization of  that  opportunity  at  a  higher  figure  than  the  price 
to  be  paid  the  original  owner  plus  the  funds  required  for 
development;  and  (3)  the  sale  of  the  certificates  of  this  cap- 
italization to  the  investor,  either  directly  or  through  the 
agency  of  middlemen,  for  a  sum  of  money  exceeding  the 
amount  necessary  to  purchase  and  develop  the  resource  which 
it  is  intended  to  exploit.  The,  difference  represents  the  pro- 
moter's profit,  a  characteristic  feature  of  corporation  finan- 
ciering. '^ 

What  have  the  promoters  done  to  entitle  them  to  this 
large  profit?  They  have  produced  no  coal;  that  is  done  by 
the  company  to  which  they  turn  over  their  options.     Nor 


20  COKPOKATION   FINANCE 

have  tliey  risked  an  amount  of  money  in  any  way  comparable 
£o  the  profit  which  they  have  made.  To  obtain  fifty  options 
under  the  circumstances  described  may  not  have  required 
an  outlay  of  more  than  $5,000.  Judged  by  the  canons  of 
what  is  generally  considered  to  be  legitimate  money  making, 
the  promoters  have  done  nothing  to  entitle  them  to  the 
$70,000  profit  which,  out  of  a  flotation  of  this  importance, 
they  frequently  take.  And  yet  the  profits  of  the  promoter 
are  as  legitimate  as  are  the  profits  of  any  of  the  more  familiar 
professions. 

The  promoter  is  a  creator  of  value.  He  brings  into  ex- 
istence a  means  of  producing  wealth  which  did  not  before 
exist.  By  combining  the  control  of  a  number  of  separate 
pieces  of  coal  property  into  a  fully  equipped  coal-mining 
enterprise,  he  is  able  to  offer  to  the  investor  an  opportunity 
to  earn  say  twenty  per  cent  net  on  his  money;  in  other 
words,  to  sell  to  the  investor  $500,000  worth  of  stock  which 
can  be  depended  on  to  pay  dividends  of  ten  per  cent,  for 
$250,000. 

Without  this  combination,  in  the  hands  of  individual 
owners,  without  transportation  facilities,  and  without  equip- 
ment, the  value  of  this  coal,  based  on  its  earning  power 
from  the  small  mines  which  produce  for  the  local  trade,  did 
not  exceed  $20  per  acre.  Combined  under  one  ownership, 
connected  with  a  trunk  line  railroad,  and  equipped  for  large 
operations,  a  value  of  $100  per  acre  is  not  excessive.  This 
increase  in  value  of  $80  per  acre  is  the  result  of  the  invest- 
ment of  $35  per  acre — $20  in  the  purchase  of  the  coal  and 
$15  in  its  development.  Deducting  the  $35  which  must  be 
spent  to  put  the  coal  on  the  market,  there  remains  $65  per 
acre  as  the  promoter's  profit,  which  he  may  share  with  the 
banker  and  investor,  a  profit  differing  in  no  essential  feature 
from  the  gains  of  the  manufacturer  who  contracts  ahead 
for  his  material  and  takes  advantage  of  a  rise  in  the  market 
price  of  his  product. 

But,  it  may  be  objected,  why  should  the  promoter  be 
allowed  to  make  this  large  profit?     Why  should  it  not  be 


THE   WORK   OF   THE   PROMOTER  21 

divided  between  the  farmer  who  owns  the  land  and  the 
investor  who  furnishes  the  money?  What  is  the  justification 
for  the  promoter's  profit?  The  answer  to  these  questions 
lies  in  the  nature  of  the  transaction.  Neither  the  owner  nor 
the  investor  can  do  the  work  of  the  promoter,  and  they  have, 
therefore,  no  claim  to  his  profits.  The  farmers,  save  in  ex- 
ceptional instances,  could  not  even  organize  their  own  propo- 
sition, much  less  finance  it.  Mutual  jealousies,  local  feuds, 
and  overmuch  information  about  the  character  and  financial 
standing  of  local  individuals  who  might  undertake  this  work 
interfere  with  any  general  agreement.  It  would  be  found 
next  to  impossible  to  agree  upon  the  proper  price  for  differ- 
ent prices  of  coal  land.  Farmer  A,  whose  land  lies  near  the 
creek,  would  insist  upon  a  higher  value  for  his  property 
than  farmer  B,  whose  coal  is  less  accessible;  while  B  on  his 
part  might  cite  as  a  reason  for  disputing  the  justice  of  A's 
claim,  the  fact  that  his  coal  had  been  opened  in  several 
places  while  nobody  knew  that  A  had  any  coal  oh  his  prop- 
erty. Farmer  C,  who  owned  land  across  the  right  of  way 
of  the  proposed  railroad,  and  who  therefore  considered  his 
cooperation  indispensable,  might  insist  upon  a  price  of  $150 
per  acre,  which  would  probably  disgruntle  his  less  favored 
and  jealous  neighbors,  and  so  defeat  the  scheme.  The  Brown 
family  might  refuse  to  go  into  any  agreement  with  the 
Jones  family,  with  whom  one  of  the  chiefs  of  the  Brown 
clan  may  have  had  a  lawsuit  of  some  years'  standing.  Any- 
one of  a  number  of  similar  causes  which  might  be  cited 
would  be  sufficient  to  prevent  the  concentration  of  control 
of  these  separate  properties,  which  are  of  small  value  unless 
combined. 

Some  one  interest  acting  exclusively  for  its  own  ad- 
vantage, and  dealing  independently  with  each  owner,  is  es- 
sential to  the  assembling  of  such  a  proposition.  This  inter- 
est may  be  local,  and,  as  already  noted,  by  means  of  local 
alliances  the  task  of  the  promoter  is  made  easier;  but  in 
most  cases,  the  successful  assembler  of  a  proposition  is  the 
outsider  who  can  pose  as  the  man  of  wealth  and  connection, 
3 


22  COKPORATION   FINANCE 

and  can  reap  his  harvest  of  options  during  the  pleasant 
weather  of  a  first  impression.  It  is  the  experience  of  pro- 
moters that  an  outsider  of  imposing  personality,  pleasing 
address,  and  experience  in  handling  men  has  usually  much 
greater  success  in  securing  options  than  even  a  local 
"  squire "  or  other  celebrity  whose  standing  in  the  com- 
munity may  be  of  the  best,  but  who  is  too  well  known  to 
be  allowed  by  his  neighbors  to  make  any  large  amount  of 
money  out  of  their  property. 

Even  if  the  farmers  succeeded  in  getting  their  proposi- 
tion together  in  the  control  of  a  selected  committee  or  in- 
dividual, they  would  have  great  difficulty  in  securing  a 
financial  connection.  They  would  have  to  provide  for  expert 
reports  on  the  property,  and  then  to  open  negotiations  with 
some  financial  interests  with  whom  none  of  their  •  members 
would  probably  be  personally  acquainted.  After  securing  an 
introduction,  they  would  present  their  proposition,  probably 
in  a  lame  and  halting  manner,  which  would  not  show  that 
they  possessed  a  comprehensive  knowledge  of  the  importance 
of  the  property  in  question  to  the  general  coal  market  or  of 
'the  cost  and  conditions  of  its  development. 

Since  they  would  have  no  connection  with  the  investing 
public,  if  the  banker  to  whdm  they  would  naturally  apply 
for  the  funds  was  sufficiently  interested  to  examine  the  prop- 
osition and  to  determine  its  value,  he  might  take  one  of 
two  ways  to  further  his  own  advantage.  He  would  either 
prolong  the  negotiations  until  the  local  contingent  lost  heart 
and  withdrew,  trusting  to  his  own  ability  to  obtain  the  options 
for  himself,  or  he  would  compel  the  representatives  of  the 
owners,  if  they  desired  his  assistance,  to  accept  a  price  not 
greatly  exceeding  the  face  of  their  options;  in  which  event 
the  financier  would  be  the  promoter  one  stage  removed,  and 
acting  by  deputy.  It  is  evident,  therefore,  that  the  larger 
part  of  the  promoters'  profits  on  such  propositions  cannot 
ordinarily  be  saved  by  the  original  owners  of  the  coal. 

The  proprietor  of  an  undeveloped  opportunity  is  seldom 
in  a  position  to  bargain  to  advantage  for  its  sale.  His  best 


UNIVERSITY 

OF         ^^^ 

^^Li^^^ORK   OF   THE   PROMOTER  23 

course  is  to  put  his  property  in  the  control  of  some  promoter 
at  a  fixed  price  and  for  a  definite  time,  contenting  himself 
with  effecting  a  sale,  not  at  the  price  which  he  thinks  the 
property  is  worth,  but  at  a  price  which  will  represent  a  fair 
return  on  his  investment  of  brains  or  money.  Any  attempt 
on  his  part  to  promote  his  own  scheme  is  likely  to  end  in 
failure.  The  failure  of  inventors  to  make  more  money  out 
of  the  sale  of  patents  which  have  merit  is  probably  due,  more 
than  to  any  other  cause,  to  the  fact  that  they  insist  upon 
an  excessive  interest  themselves,  and  are  unwilling  to  offer 
sufficient  inducements  to  those  who  might  otherwise  promote 
the  scheme. 

It  is  equally  impossible  for  the  investor  to  secure  the 
promoters'  profits.  The  investor  is  looking  for  a  security 
which  will  produce  as  large  an  income  as  is  consistent  with 
the  safety  of  his  principal.  He  is  not  likely  to  concern  him- 
self with  the  active  management  of  these  industries  into 
which  he  puts  his  money.  How  much  less  likely  is  he,  there- 
fore, to  abandon  his  regular  business  or  profession  and  roam 
about  the  country  in  search  of  resources  to  develop.  The 
investor,  of  necessity,  assumes  a  receptive  attitude.  He  is 
the  customer  to  whom  the  promoter  and  financier  offer  their 
wares.  He  buys  on  his  judgment,  not  so  much  of  the  merits 
of  the  proposition,  as  of  the  reputation  of  those  who  offer 
it  for  sale. 

We  must  conclude,  therefore,  that  the  promoter  performs  \ 
an  indispensable  function  in  the  community  by  discovering,    ^ 
formulating,   and    assembling   the  business   propositions    by  • 
whose  development  the  wealth  of  society  is  increased.     He 
acts  as  the  middleman  or  intermediary  between  the  man  with 
money  to  invest  in  securities  and  the  man  with  undeveloped 
property  to  sell  for  money.    In  the  present  scheme  of  produc- 
tion, the  resource  and  the  money  are  useless  apart.    Let  them 
be  brought  together  and  wealth  is  the  result.    The  unassisted 
coincidence  of  investment  funds  with   investment  opportu- 
nities, however,  is  uncertain.     The  investor  and  the  land  or 
patent  or  mine  owner  have  few  things  in  common.     Left 


24  COEPOKATION   FINANCE 

to  themselves  they  might  never  meet.  But  the  promoter 
brings  these  necessary  elements  together,  and  in  this  way 
is  the  means  of  creating  a  value  which  did  not  before  exist, 
and  which  is  none  the  less  a  social  gain  because  much  of  its 
is  absorbed  in  the  first  instance  by  the  promoter  and  the 
financier. 


CHAPTER    III 
THE  TRUST— ITS  PROMOTION  AND  EVOLUTION 

We  have  next  to  examine  the  application  of  the  principles 
of  promotion  in  the  formation  of  the  industrial  combinations. 
In  the  present  form,  companies  such  as  the  United  States 
Steel  Corporation,  the  American  Locomotive  Company,  and 
the  American  Smelting  &  Refining  Company,  are  corpo- 
rations organized  under  the  laws  of  the  State  of  New 
Jersey,  and  authorized  by  their  charters,  among  other  pow- 
ers, to  hold  the  stocks  and  securities  of  certain  corporations 
engaged  in  the  same  or  kindred  industries.  These  companies 
have  either  exchanged  their  stocks  for  the  stocks  and  prop- 
erty of  a  large  number  of  small  concerns  located  in  the 
various  producing  localities  of  their  respective  industries,  or 
they  have  sold  their  own  securities,  and  with  the  proceeds 
have  purchased  the  stocks  and  property  of  the  various  con- 
cerns which  they  wish  to  acquire  from  those  owners  who 
were  unwilling  to  receive  their  stocks  and  bonds  in  exchange 
for  their  property  and  who  demanded  cash.  The  result  of 
the  trust  development  has  been  the  creation  of  a  large 
number  of  huge  corporations  which  control  many  of  the 
largest  industries  of  the  United  States.  The  methods  by 
which  these  companies  were  brought  together,  capitalized, 
and  financed  constitute  one  of  the  most  interesting  chapters 
in  American  economic  history.  Since  these  operations  were 
largely  carried  on  in  the  open,  they  enable  us  to  illustrate 
in  detail  the  principles  of  the  promotion  of  companies. 

The  proposition  which  the  trust  promoter  attacked  was 
the  consolidation  of  a  large  number  of  competing  plants  in 

25 


26  COKPOKATION   FINANCE 

a  particular  industry.  He  proposed  to  form  a  corporation 
to  purchase  these  plants,  either  directly  or  by  acquiring  the 
stock  of  the  companies  which  owned  them.  Instead  of  fifteen, 
twenty,  or  thirty  firms  and  companies  engaged  in  competi- 
tion, the  promoter  planned  to  substitute  one  large  corpora- 
tion which  should  include  every  plant  of  importance  in  the 
competing  territory.  There  was  to  be  but  one  corporation 
in  each  industry — one  wire  company,  one  bicycle  company, 
one  tube  company,  one  company  manufacturing  tin  plate. 

The  value  of  each  of  the  plants  which  it  was  proposed 
to  include  in  the  new  trust  was  based  upon  its  earning  power. 
That  earning  power  was  greatly  reduced  by  competition. 
The  promoter  expected  to  option  each  plant  at  a  figure 
which  should  represent  its  past  earnings,  organize  a  company 
with  a  capitalization  which  should  represent  the  increased 
earning  power  of  these  plants  when  competition  had  been 
eliminated,  and  sell  the  stock  of  this  corporation  to  the 
public. 

The  advantage  promised  by  this  operation  was  the  same 
as  that  of  the  coal-land  proposition.  By  combining  a  large 
number  of  small  holdings  under  one  ownership,  and  properly 
equipping  the  property  for  large  operations,  the  value  of 
coal  land  can  be  increased  from  $20  to  $100  per  acre.  Out 
of  the  securities  representing  this  valuation,  the  promoter 
can  equip  the  property  and  have  a  large  profit  remaining. 
The  average  value  of  the  thirty  plants  which  the  promoter 
desires  to  combine  into  a  trust,  when  engaged  in  mutually 
reducing  profits  by  competition,  may  be  $500,000.  This 
figure  is  the  capitalization  of  their  average  earning  power 
at  $50,000  per  year.  Combine  all  these  plants  under  one 
ownership,  thus  eliminating  competition,  and  you  have  in- 
creased this  average  value  from  $500,000  to  perhaps  $750,000. 
The  enterprise  can,  therefore,  be  capitalized  at  $22,500,000 
of  stock,  and  this  stock  can  be  sold  for  a  sum  of  money  suf- 
ficient to  take  up  the  options,  equip  the  corporation  with 
working  capital,  and  leave  a  substantial  margin  of  profit  to 
the  promoter.    This,  then  was  the  advantage  which  the  trust 


THE   TKUST  .  27 

promoter  sought  to  obtain — to  capitalize  the  economies  of 
combination^  sell  the  certificates  of  the  capital,  and  obtain 
a  share  of  the  proceeds  as  his  own  profit. 

His  work  was  to  assemble  his  proposition — to  get  the 
plants  under  option.  To  this  end,  he  had  to  convince  the 
manufacturers  that  his  scheme  would  be  successful,  that  its 
industrial  basis  was  sound  and  its  financial  support  assured, 
and  he  had  further  to  offer  to  each  owner  and  stockholder 
a  sufficient  inducement  to  sell.  The  first  part  of  the  pro- 
moter's task  was  less  difficult  than  the  second. 

The  desire  to  eliminate  competition  was  the  principal 
reason  for  the  formation  of  the  trusts.  From  the  producer's 
standpoint,  this  was  a  convincing  reason.  The  promoter 
could  name  several  important  advantages  to  result  from  the 
acceptance  of  his  proposals.  Most  important  was  the  con- 
trol of  prices.  Combination  secures  more  stable  prices  to 
the  producers,  and  also  enables  them  to  accommodate  their 
quotations  to  the  state  of  trade.  When  business  is  brisk 
and  the  demand  for  their  product  increasing,  they  are  not 
impelled  by  fear  of  competition  to  tie  themselves  to  a  low 
price  level  by  contracting  for  a  year  ahead.  Contracts  can 
be  readjusted  by  a  combination  at  short  intervals  so  as  to 
compel  the  large  consumer  to  pay  an  increasing  price. 

With  competition  eliminated,  the  manufacturer  is  able  to 
charge  what  the  traffic  will  bear',  to  get  from  the  buyer  all 
that  the  buyer  can  be  induced  to  pay,  and  he  is  no  longer 
compelled  to  divide  his  profits  with  middlemen  and  secondary 
producers.  For  the  same  reason,  when  prices  are  falling,  a 
combination  is  less  exposed  to  the  reckless  cuts  and  sacrifice 
sales  with  which  hard  pressed  individual  concerns  at  such  a 
time  are  constantly  threatening  the  market.  It  is  true  that 
if  mills  are  to  be  kept  in  full  operation  prices  must  be  low- 
ered when  demand  declines,  but  the  reductions  can  be  made 
gradually  and  tentatively,  so  that  the  buyer  is  at  all  times 
made  to  pay  all  that  he  can  afford  to  pay,  and  gains  no  unrea- 
sonable advantage. 

Moreover,  if  the  depression  is  temporary,  due  to  special 


28  COKPORATION   FINANCE 

and  exceptional  causes,  such  as  a  stock  panic  or  a  foreign 
war,  while  the  industrial  condition  of  the  country  is  satis- 
factory, a  combination  in  control  of  the  market  can  sharply 
reduce  production,  and  in  this  way  sustain  prices  until  con- 
fidence returns.  Under  competition,  a  large  part  of  the  ad- 
vantage gained  by  the  increased  demands  of  prosperity  has 
often  been  sacrificed  by  a  temporary  setback.  The  mutual 
distrust  of  producers  at  such  a  time  stands  in  the  way  of 
any  restriction  of  output,  and  prices  are  allowed  to  sag  at 
the  dictation  of  the  buyer,  until  when  the  sky  is  again  clear, 
the  mills  are  committed  to  prices  much  lower  than  the  cir- 
cumstances of  the  buyer  warrant. 

Combination  also  enables  the  manufacturers  to  hold  the 
buyers  to  their  contracts.  Mr.  Gates  discussed  this  advantage 
before  the  Industrial  Commission.  "  Q.  How  is  it  that  your 
power  is  greater  under  this  (system)  ?  A.  Well,  under  the 
old  system  a  merchant  might  quibble  with  half  a  dozen 
manufacturers,  and  there  might  be  some  one  particular  manu- 
facturer that  lie  would  treat  fairly,  so  that  he  would  feel  that 
he  had  a  port  in  a  storm.  And  in  the  commercial  term  men 
claim  shortage,  make  unreasonable  demands,  and  we  do  not 
find  these  demands  to  exist  to  any  such  extent  as  they  did 
before.  They  claimed  a  shortage,  for  instance,  of  five  kegs 
of  nails  or  five  spools  of  wire  and  if  we  accepted  their  state- 
ment we  had  to  fight  it  out  with  the  railroad  company.  We 
had  a  check,  and  we  thought  we  knew  we  were  correct,  and 
now  we  are  pretty  apt  to  be  firm.  We  will  always  consider 
their  claims,  but  we  will  not  allow  them  freely,  perhaps,  as 
we  would  before;  they  have  to  be  very  thoroughly  well 
founded  on  fact  for  us  to  make  allowance." 

When  competition  has  been  supplanted  by  combination, 
the  unruly  buyer  has  no  "  port  in  a  storm."  Should  he 
prove  refractory,  as  Mr.  Gates  said,  "the  only  pressure  we 
could  bring  to  bear  would  be  to  ask  him  to  send  a  draft  with 
the  order,"  a  "  pressure  "  quite  sufficient  to  suggest  modera- 
tion in  demands  for  readjustments  of  contracts.  The  same 
discipline  was  applied  to  correct  the  abuse  of  long  delays  in 


THE   TRUST  29 

settling  for  orders.  Another  important  advantage  secured 
by  centralized  control  is  found  in  dealing  with  railroads  and 
producers  of  materials.  Many  of  the  concerns  which  united 
to  form  the  trusts,  although  their  aggregate  purchases  and 
shipments  ran  up  into  the  millions  of  tons,  were  individually 
too  weak  to  secure  the  most  favorable  rates  and  prices.  They 
were  often  subject  to  discriminations  in  favor  of  the  large 
producers  in  the  same  trade.  This  is  illustrated  by  the  de- 
velopment of  certain  large  coal  mining  concerns  which  have 
grown  in  former  years,  somewhat  at  the  expense  of  their 
weaker  competitors,  by  rebates  received  from  the  railroad, 
and  the  concessions  in  car  supply,  speedy  delivery  and  free 
storage  on  track,  all  of  which  advantages  enabled  these  spe- 
cially favored  companies  not  merely  to  underbid  their  com- 
petitors, but,  what  is  often  of  more  consequence,  to  execute 
orders  with  dispatch. 

Vexatious  delays  are  experienced  by  every  small  buyer 
in  a  time  of  active  demand.  He  must  wait  until  the  wants 
of  his  more  important  rivals  have  been  supplied,  and  waiting 
means  a  loss  of  valuable  business  which  is  pressing  for  ex- 
ecution. A  large  buyer,  moreover,  can  make  a  large  contract 
at  low  prices,  while  the  small  buyer  is  shifted  about  with 
every  turn  in  the  market.  These  disabilities  under  which 
the  individual  concerns  labored,  it  was  evident,  could  be 
largely  removed  by  combining  them  into  a  single  organization 
which  could  obtain  in  its  negotiations  all  the  advantages 
which  had  hitherto  been  enjoyed  only  by  the  largest  manu- 
facturers. 

In  their  relations  with  the  jobbing  trade  manufacturers 
are  strengthened  by  combination.  Two  illustrations  of  this 
advantage  may  be  given:  Manufacturers  of  hardware,  under 
competitive  conditions,  have  always  been  greatly  injured  on 
every  occasion  of  increasing  demand  by  the  practice  of  large 
jobbers  who  had  purchased  heavily  before  the  advance  in 
reselling  to  other  jobbers  at  prices  less  than  those  charged 
by  the  manufacturers,  and  also  demoralizing  the  retail  trade 
and  interfering  with  the  free  distribution  of  goods,  by  selling 


30  COKPOKATION   FINANCE 

at  cut  prices  to  retailers,  thus  preventing  less  fortunate 
wholesalers  from  making  their  usual  sales  and  lessening  their 
demands  upon  the  factory.  The  injury  inflicted  upon  the 
manufacturer  by  the  practice  of  contracting  ahead  is  mainly 
due  to  the  irregularity  of  prices  which  are  made  by  belated 
buyers.  The  reselling  and  underselling  of  large  jobbers  was, 
in  the  lines  of  furnished  hardware,  an  evil  equally  serious,  and 
was  directly  due  to  the  competitive  struggle,  which  forced  the 
manufacturer  to  take  business  no  matter  how  unfavorable 
might  be  the  terms  on  which  it  was  offered. 

This  necessity  of  forced  selling  also  ena  ..  cl..>'s  of 

jobbers  to  exist  who  secured  trade  by  questionable  methods 
— for  example,  by  dividing  their  profits  with  the  retailer,  the 
result  being  that  the  best  customers  of  the  manufacturer 
had  their  profits  greatly  curtailed  and  were  forced  to  reduce 
their  demands,  unless  the  manufacturer  also  descended  to 
the.  lower  level  of  prices  and  profits.  On  the  other  hand, 
manufacturers,  in  their  anxiety  to  get  business,  often  ad- 
dressed the  retailer  direct.  This  method  of  distribution  is 
expensive  to  the  manufacturer.  He  must  charge  the  cost 
of  maintaining  an  extensive  selling  and  collecting  depart- 
ment, and  of  shipping  in  small  lots,  against  a  single  line  of 
goods,  no  great  quantity  of  which  can  be  sold  to  anyone 
dealer,  while  the  jobber,  handling  hundreds  of  lines,  can  sup- 
ply the  retailer  with  a  complete  stock,  charging  the  expenses 
of  selling  against  a  $500  order,  although  the  manufacturer 
of  axes,  locks,  or  stoves  could  sell  perhaps  only  one  tenth 
or  one  twentieth  as  much.  It  is,  therefore,  to  the  manu- 
facturer's interest  that  the  jobber  be  protected  against  such 
irregular  methods,  for  the  jobber  is  his  best  customer.  A 
half  dozen  jobbers  will  take  the  entire  output  of  a  nail  mill, 
and  thus  relieve  the  manufacturer  of  all  expense  and  risk 
of  selling  and  collection. 

By  combining  and  eliminating  competition  these  evils  are 
abated.  The  jobbers  can  be  held  to  small  orders,  and  the 
resulting  necessity  of  frequent  purchase  tends  to  deter  them 
from  cutting  prices.    They  are  forced  to  deal  with  the  com- 


THE   TRUST  31 

bination,  and  must  obey  the  rules  which  it  lays  down  to 
regulate  their  purchases.  While  the  jobbers  are  held  to 
stricter  account,  and  prevented  from  competing  with  the 
manufacturer  or  by  other  methods  demoralizing  to  trade,  they 
are,  on  the  other  hand,  favored  and  helped  by  the  combina- 
tion refusing  to  sell  to  retail  dealers  even  when  these  order 
in  jobbers'  lots,  and  cutting  off  the  supply  of  any  jobber  who 
is  detected  in  dividing  his  profits  with  the  retailers.  By  con- 
fining their  sales  to  the  jobbers,  the  combined  manufacturers 
can  sell  at  lower  figures  for  large  lots,  and  in  this  way  can 
protect  the  jobber  in  a  larger  margin  of  profit  than  he  could 
secure  under  competitive  conditions  when  the  retail  trade 
was  given  such  improper  advantages  in  buying.  The  elimi- 
nation of  competition,  then,  improves  the  relations  between 
buyer  and  seller,  and  secures  the  manufacturer  in  a  larger 
and  more  regular  demand  for  his  product. 

One  final  advantage  secured  by  combination  deserves  spe- 
cial notice.  This  is  the  improved  position  of  the  manufac- 
turer in  dealing  with  labor.  From  the  manufacturer's  stand- 
point the  insistent  demand  of  organized  labor  for  higher 
wages  and  shorter  hours  is  equivalent  to  a  demand  that  the 
manufacturer  should  submit  to  a  reduction  of  his  profit. 
These  demands  his  business  training  teaches  him  to  resist. 
Under  the  system  of  competition,  however,  in  resisting  the 
demands  of  his  employees  he  is  placed  at  a  serious  disadvan- 
tage. For  these  employees  are  organized  into  great  unions 
containing  20,000,  40,000,  90,000  or  even  250,000  men,  under 
the  control  of  a  single  executive  board  which  secures  a  united 
action  of  the  entire  membership  of  the  union  upon  any  matter 
of  common  interest.  Competition  in  the  field  of  skilled  labor 
has  been  largely  eliminated  and  well  organized  combination 
has  long  since  taken  its  place.  These  contests  between  em- 
ployer and  employees  are  unequal.  The  manufacturer  has 
pressing  obligations  to  meet  by  the  sale  of  his  product.  In 
order  to  meet  these  obligations  he  must  fill  his  contracts  and 
hold  his  customers.  His  financial  position  is  not  strong 
enough  to  permit  a  long  continued '  suspension  of  his  plant. 


32  COKPOKATION   FINANCE 

He  is  hard  pressed  by  competitors  who  are  doing  their  -ut- 
most to  persuade  his  customers  away  from  him.  He  stands 
alone,  struggling  for  business  with  concerns  whose  hands  are 
against  him  as  his  hands  are  against  all  his  rivals. 

To  the  manufacturer  in  this  situation  comes  an  official  of 
the  International  Association  of  Machinists,  or  of  the  Amal- 
gamated Association  of  Machinists,  or  of  the  Amalgamated 
Association  of  Iron  and  Steel  Workers,  or  the  Iron  Molders' 
Union  of  America,  with  a  peremptory  demand  for  a  reduc- 
tion of  hours,  or  an  increase  in  wages,  or  the  admission  of 
walking  delegates  to  the  shop,  or  the  limitation  of  the  num- 
ber of  apprentices,  or  the  discharge  of  all  nonunion  men. 
All  or  any  number  of  these  demands  may  be  made  upon  the 
manufacturer.  If  he  refuses,  a  strike  is  the  alternative.  His 
men  will  walk  out  at  a  word  from  their  general  officers,  and 
there  will  be  none  to  take  their  places. 

The  business  instincts  of  the  manufacturer  lead  him  to 
refuse  an  advance  in  wages  as  he  would  resist  an  increase 
in  the  appraisal  of  his  plant  for  purpose  of  taxation.  He 
may  feel  that  his  men  are  receiving  high  wages — perhaps  the 
proposition  is  to  raise  them  from  $3.50  to  $4  per  day.  He 
looks  upon  the  proposed  reduction  in  hours  as  equivalent  to 
a  reduction  of  output,  opposed  not  merely  to  his  own  inter- 
ests, but  to  those  of  his  employees.  A  demand  that  outsiders 
should  dictate  the  management  of  his  business  he  regards  as 
effrontery.  His  judgment  is  unalterably  opposed  to  granting 
the  demands  of  the  union.  Each  one  of  his  competitors  may 
feel  the  same  way.  In  the  absence  of  competition  they 
would  unanimously  refuse  to  make  the  concessions  demand- 
ed. They  would  even  welcome  a  strike  as  offering  an  oppor- 
tunity to  break  the  power  of  the  union.  They  would  con- 
centrate their  efforts  on  the  plants  in  which  the  union  was 
weakest,  sending  thither  all  nonunion  men  that  could  be 
secured,  filling  as  many  orders  as  possible  from  these  plants, 
and  appealing  to  the  sympathy  of  their  customers  to  induce 
them  to  be  patient  with  the  delay  involved  in  breaking  the 
strike.     They  would  collect  a  large  defense  fund,  scour  the 


THE   TKUST  33 

country  for  nonunion  men,  educate  unskilled  labor  into  a 
knowledge  of  machines  and  processes,  secure  the  assistance 
of  the  courts  in  protecting  nonunion  men  from  interference, 
and  by  gradually  increasing  their  working  force  they  would 
reopen  first  one  mill  and  then  another.  Finally,  the  reserve 
funds  of  the  strikers  would  be  exhausted,  their  courage  weak- 
ened by  such  determined  resistance,  their  confidence  in  their 
leaders  impaired,  and  the  solid  wall  of  their  resistance  honey- 
combed with  disaffection,  until,  first  singly,  and  then  by 
hundreds,  they  would  resume  work  and  the  union  officials, 
to  save  their  organization,  would  concede  their  defeat  and 
make  an  abject  surrender.  Such  would  be  the  usual  result 
of  general  strikes  were  unanimous  action  among  employers 
to  be  secured.  Such  was  the  result  of  the  strike  of  the 
United  States  Steel  Corporation  employees  in  1901. 

Under  competition,  however,  such  unanimous  action  is 
next  to  impossible  to  attain.  Few  employers  feel  safe  in 
standing  out  against  the  union  and  thus  precipitating  a 
strike,  for  fear  lest  some  of  their  competitors  should  grant 
the  demands,  keep  their  mills  running,  get  the  orders  which 
the  strike  prevented  them  from  executing  or  accepting,  and 
in  the  profits  from  which  these  suspected  competitors  might 
find  ample  compensation  for  the  concessions  in  wages,  and 
hours  which  had  been  made  to  secure  this  increased  business 
from  less  complaisant  rivals.  Especially  with  the  owners  of 
the  weaker  mills  do  such  considerations  have  weight.  They 
hasten  to  take  advantage  of  an  opportunity  to  secure  the 
trade  of  the  best  mills,  which  are  usually  the  last  to  grant 
the  demands  of  the  strikers.  In  the  strike  of  the  Interna- 
tional Association  of  Machinists,  in  1901,  a  large  number 
of  the  strikers  almost  immediately  obtained  the  nine-hour- 
day,  but  they  were  most  of  them  employed  in  the  smaller 
shops,  which  took  this  easy,  if  short-sighted,  method  to  fill 
their  books  with  orders. 

Combination  was,  on  the  foregoing  account,  greatly  de- 
sired by  manufacturers  in  order  that  by  its  means  the  menac- 
ing growth  of  the  power  of  organized  labor  might  be  checked. 


34  CORPORATION   FINANCE 

and  the  manufacturers,  freed  from  restraints  of  mutual 
distrust  and  suspicion  which  competition  had  fastened  upon 
them,  might  stand  firmly  together  against  what  they  believed 
to  be  the  unreasonable  demands  of  the  unions. 

.  Other  advantages  might  be  mentioned  which  influenced 
manufacturers  toward  combination:  The  concentration  of 
office  forces,  distribution  of  special  processes  and  patents, 
employment  of  the  best  talent  to  raise  the  standards  of  all 
plants  up  to  the  level  of  the  best,  savings  in  cross  freights, 
alliances  with  banks  and  lower  interest  rates  thus  resulting, 
and  savings  in  reducing  the  numbers  and  salaries  of  selling 
agents  and  the  cost  of  advertising.  A  number  of  important 
functions  can  be  centralized:  auditing,  finance,  advertising, 
construction  and  engineering,  purchasing,  can  all  be  carried 
on  from  a  central  office,  at  reduced  expenses  and  with  greater 
efficiency.  Mills  can  be  specialized  to  different  products,  un- 
profitable plants  can  be  closed.  The  trust  promoter,  there- 
fore, had  at  the  outset  a  great  advantage.  Necessity  had 
long  been  working  in  his  behalf.  The  manufacturers  with 
whom  he  dealt  were  convinced  beforehand  that  his  proposi- 
tion, from  the  industrial  standpoint,  was  fundamentally 
sound.  Indeed,  so  general  was'  the  sentiment  in  favor  of 
combination  that  leading  manufacturers  in  every  trade  which 
it  was  desired  to  consolidate  were  prominent  in  urging  upon 
their  associates  the  merits  of  the  scheme. 

In  some  instances,  indeed,  the  persuasive  part  of  the  pro- 
moter's task  was  performed  for  him.  The  American  Tin 
Plate  Company  was  organized,  as  the  president  of  the  com- 
pany has  been  already  quoted  as  saying,  "  for  the  purpose 
of  getting  together  to  do  away  with  foolishness  in  making 
prices."  The  tin-plate  manufacturers,  convinced  that  they 
had  much  to  gain  from  getting  together,  held  a  meeting  and 
appointed  a  committee  to  wait  upon  Judge  William  H. 
Moore,  who  had  attained  a  considerable  reputation  as  a  com- 
pany promoter,  and  invited  him  to  undertake  the  consolida- 
tion of  the  tin-plate  mills.  Judge  Moore  tells  the  story  of 
the  invitation  as  follows :  "  I   had  organized  the  National 


THE   TRUST  35 

Biscuit  Company,  or  while  I  was  organizing  the  National 
Biscuit  Company,  a  committee  of  manufacturers  called  on 
me  in  New  York  and  requested  me  very  urgently  to  take 
hold  of  the  organization.  At  that  time  (they  stated  after- 
wards) they  thought  I  was  not  very  enthusiastic  about  it. 
I  was  very  busy,  and  I  knew  it  was  a  difficult  thing  to  do. 
The  result  was,  it  was  delayed  two  or  three  months.  As  I 
learned,  they  had  meetings  in  Pittsburg,  and  possibly  other 
places,  and  they  came  to  me  again.  So  it  ran  over  a  period 
of  a  year  or  a  year  and  a  half  from  the  time  they  first  called 
on  me  until  the  final  organization  of  the  company."  Here 
was  a  proposition  already  prepared  for  the  promoter. 

The  consolidation  of  the  American  Sheet  Steel  Company 
by  the  same  promoter  was  also  undertaken  at  the  instance 
of  the  owners,  whose  situation  is  thus  described  by  the  Iron 
Age,  of  February  22,  1900 :  "  It  was  easy  to  see  that  the  sheet 
trade  was  in  a  hopeless  condition,  and  that  something  would 
have  to  be  done  and  that  very  speedily.  There  was  fear 
that  sheets  would  be  dumped  on  the  market  by  some  mills 
in  order  to  realize  money,  and  this  aggravated  the  situation. 
Options  were  again  renewed,  and  progress  on  the  deal  was 
rapid  from  the  fact  that  the  mills  recognized  the  hopeless 
position  they  were  in  with  high-priced  sheet  bars  and  very 
low-priced  sheets." 

The  American  Car  &  Foundry  Company  was  promoted 
by  men  who  were  large  owners  of  the  stock  of  the  Michigan 
Peninsular  Car  Company,  a  company  organized  in  1892, 
which  had  greatly  disappointed  its  promoters  and  under- 
writers by  failing  to  show  the  earnings  which  had  been  pre- 
dicted. By  uniting  a  number  of  competing  plants  with  this 
company,  it  was  thought  that  its  position  could  be  greatly 
improved. 

The  question  now  arises :  why,  if  the  advantages  of  com- 
bination were  so  well  understood,  did  not  the  manufacturers 
form  their  own  company  without  the  assistance  of  an  out- 
sider ?  The  answer  is  found  in  the  reasons  presented  in  the 
last  chapter  to  show  how  difficult  it  was  for  individual  land- 


36  COBPORATION  FINANCE 

owners  to  assemble  a  coal  mining  proposition.  The  manu- 
facturers could  not  agree  as  to  the  valuation  to  be  placed 
upon  their  plants  in  the  new  combination.  As  Judge  Moore 
described  it :  "  Each  manufacturer  imagines  his  plant  is  bet- 
ter located,  better  than  his  neighbor's;  he  knows  it  is,  he 
has  no  doubt  about  it.'' 

One  manufacturer  has  patents  and  special  machinery 
which  have  cost  him  a  great  deal  of  money  and  by  which  he 
sets  much  store.  He  will  not  enter  the  proposed  combination 
unless  these  costs  are  made  up  to  him.  Another  manufac- 
turer may  have  a  large  productive  capacity,  fifty  nail  ma- 
chines, for  example.  He  may  have  been  unable  to  find  a 
market  for  the  output  of  more  than  half  his  machines,  but 
in  the  combination,  he  contends,  all  this  capacity  will  become 
available.  He,  therefore,  insists  that  productive  capacity 
should  be  the  basis  on  which  the  allotment  of  shares  in 
the  trust  should  be  made.  A  third  man,  by  the  excellence- 
of  his  equipment  and  the  energy  of  his  methods,  has  been 
able  to  run  his  plant  at  its  full  capacity,  while  his  competitor, 
with  a  larger  productive  capacity,  but  a  less  favorable  loca- 
tion or  a  less  capable  body  of  subordinates,  has  operated 
only  half  time.  The  successful  manufacturer  contends  that 
average  sales  should  be  the  basis  of  allotment. 

Here  are  three  propositions  for  the  apportionment  of  in- 
terest in  the  trust:  money  invested,  productive  capacity,  and 
average  sales.  Each  is  entirely  distinct.  No  one  of  the  three 
can  be  accepted  without,  in  the  opinion  of  the  authors  of 
the  rejected  propositions,  jeopardizing  their  interests.  If 
money  invested  be  accepted  as  the  basis  of  apportionment, 
then  producer  A  will  receive  $500,000  of  stock  out  of  say 
$10,000,000,  or  one  twentieth  of  the  property  of  the  combina- 
tion, when  on  the  basis  of  his  total  sales  he  would  be  entitled 
to  only  half  this  interest,  or  $250,000.  Producer  B,  on  his 
part,  demands  that  his  idle  capacity  be  considered,  while  C 
insists  that  although  he  may  have  put  only  $100,000  into  his 
mill,  yet  since  his  sales  amount  to  one  tenth  of  the  total,  he 
should  have  $1,000,000  of  stock.     Each  of  the  three  knows 


•  THE   TRUST  37 

the  claims  of  the  other  two  and  considers  them  to  be  un- 
reasonable. There  is  no  common  ground  of  agreement,  no 
basis  for  compromise.  Two  of  the  three  must  abandon  their 
positions  if  the  combination  is  to  be  effected. 

An  illustration  is  in  place.  In  the  manufacture  of  stoves 
a  great  deal  of  money  is  annually  invested  in  patterns.  These 
patterns  are  used  not  longer  than  ten  years.  New  designs 
are  always  being  introduced,  and  if  they  prove  popular  the 
demand  for  the  old  designs  of  stoves  and  ranges  and  the 
value  of  the  old  patterns  is  correspondingly  reduced.  It  is, 
however,  customary  to  preserve  these  patterns,  which  are 
usually  patented,  in  the  expectation  that  old  styles  may  be 
revived,  and  also  to  protect  against  infringement.  A  firm 
in  Philadelphia  has  preserved  all  the  patterns  of  forty  years 
of  manufacturing.  Now  it  is  plain  that  the  amount  of  money 
invested  in  such  an  accumulation  of  out-of-date  designs  is  no 
criterion  of  the  value  of  these  patterns  to  a  stove  trust.  A 
plant  which  had  been  running  only  five  years  might  have 
only  $20,000  invested  in  patterns,  while  an  old  plant  might 
have  spent  as  much  as  $400,000  on  its  patterns,  yet  the  sales 
of  Plant  No.  1  might  exceed  by  $20,000  per  year  the  sales 
of  Plant  No.  2.  If  the  old  plant  insisted  upon  $400,000  of 
stock  for  its  patterns  because  so  much  money  had  been  in- 
vested in  them,  its  demands  could  be  granted  only  at  the 
expense  of  the  new  plant,  whose  earning  power  is  much 
greater.  Yet  such  demands,  it  was  stated,  were  made  by 
more  than  one  manufacturer  during  an  attempt  to  con- 
solidate this  trade,  and  it  was  found  impossible  to  persuade 
them  to  recede  from  their  position. 

It  might  appear  to  the  outsider  who  looked  at  the  ques- 
tion dispassionately,  that  the  earning  power  of  a  plant  fur- 
nished the  only  basis  for  determining  its  value.  Earning 
power,  however,  is  subordinated  in  the  minds  of  many  people 
to  money  invested,  and  there  is  usually  enough  obstinacy  and 
jealousy  in  a  group  of  competitors  to  prevent  a  solution  of 
the  question  along  rational  lines.  The  scars  of  the  compet- 
itive struggle  are  too  deep  and  its  feuds  are  too  ancient  to 
4 


38  COKPOKATION   FINANCE 

induce  one  manufacturer  to  allow  his  rivals  to  gain  an  ad- 
vantage over  hiih. 

Moreover,  earning  power  is  a  variable  quantity.  Here  is 
a  reckless  competitor  who  has  been  demoralizing  the  trade 
in  a  certain  section  by  selling  to  the  retail  trade,  lowering 
the  standard  of  his  product,  and  undercutting  his  more  pub- 
lic-spirited rival,  who  has  preferred  to  let  his  mill  be  idle 
for  a  part  of  the  year  rather  than  to  sacrifice  his  business 
principles.  If  this  wrecker  of  trade  can  be  eliminated,  the 
earning  power  of  the  second  plant  may  be  increased  fifty  per 
cent.  Is  not  the  owner  of  that  plant  warranted  in  demand- 
ing that  his  mill  will  be  worth  more  to  the  trust  than  its 
present  earning  power  would  indicate? 

It  is  next  to  impossible  to  form  a  trust  in  a  caucus  of 
manufacturers.  A  pool  can  be  arranged  with  less  trouble. 
A  pool  is  a  temporary  organization  from  which  any  member 
can  secede  at  short  notice.  The  ownership  of  each  plant  is 
in  no  way  disturbed.  When  the  manufacturer  goes  into  a 
trust,  however,  his  property  passes  out  of  his  possession,  he 
has  sold  his  plant  for  cash  or  stock,  and  he  scrutinizes  with 
great  care  the  terms  of  sale. 

Out  of  this  situation  arises  the  necessity  of  the  promoter. 
The  promoter  is  the  outsider  who  offers  to  purchase  each 
plant  in  a  separate  deal  without  reference  to  the  price  paid 
for  the  other  mills.  ^  By  d€t&ii«^  separately  with  eaeh  group 
of  owners  he  a  voids,  the  obstacles  of  a^  mutual  compiirison  of 
valuations,  and  can  attack  the  proposition  with  some  hope 
of  success.  Mr.  Flint,  testifying  before  the  Lexow  Com- 
mission for  the  Investigation  of  Trusts,  explained  the  neces- 
sity for  the  promoter  as  follows :  "  Q.  How  can  you  explain 
io  the  Committee  the  fact  that  combinations  of  legitimate 
business  enterprises  have  to  be  made  the  subject  of  pro- 
moters' agreements — have  to  be  placed  through  banking 
establishments  in  Wall  Street — if  they  are  the  normal  out- 
come of  a  demand  of  the  businesses  themselves  to  enter  into 
combination  with  each  other?  A.  For  the  same  reason  that 
men  of  high  intelligence  are  needed  to  make  treaties  between 


THE   TKUST  39 

the  nations,  particularly  during  periods  of  war.  Q.  You 
mean  it  is  a  delicate  diplomatic  situation  that  has  to  be  met  ? 
A.  It  is  one  that  requires  the  very  highest  intelligence,  and, 
as  a  rule,  neutral  parties — parties  not  interested,  men  of  the 
intelligence  and  reputations  to  inspire  unlimited  confidence 
on  the  part  of  manufacturers,  are  needed  to  bring  manu- 
facturers together  in  order  that  they  may  move  with  the 
current  of  natural  laws.  The  advantage  of  a  neutral  party, 
of  a  banker,  is  that  he  is  in  a  position  unlike  another  in  the 
same  trade,  to  get  at  the  facts  ...  to  reduce  the  pretensions 
— the  exaggerated  pretensions  of  the  manufacturers,  and 
bring  their  minds  together  upon  a  reasonable  and  proper 
basis." 

Mr.  Flint  has  here  succinctly  stated  the  function  of  the 
promoter  in  the  organization  of  the  trust.  "Natural  law," 
it  is  true,  impels  the  manufacturers  to  unite — without  the 
existence  of  a  strong  desire  for  combination  the  task  of  the 
promoter  would  be  impossible — but  individual  jealousy,  ig- 
norance, prejudice,  and  inertia  interfere  with  and  impede 
the  operation  of  the  natural  law  of  advantage;  and  coopera- 
tive methods  must  be  abandoned  in  order  that  the  benefits 
secured  by  combination  may  be  brought  home  to  each  manu- 
facturer without  reference  to  the  stock  interest  that  his  com- 
petitor may  secure. 

The  promoter,  being  appealed  to  by  the  manufacturers 
who  may  have  failed,  as  did  the  tin-plate  manufacturers,  to 
succeed  by  cooperative  methods,  addresses  himself  to  the 
second  part  of  his  task — to  secure  options  upon  the  separate 
plants  at  a  figure  less  than  the  capitalized  earning  power  of 
the  combination  he  proposes  to  form,  which  difference  will 
represent  his  profit.  He  does  not  work  on  commission ;  that 
would  make  him  merely  the  agent  of  the  manufacturers,  and 
would  be  cooperation  by  deputy,  a  method  as  futile  as  co- 
operation direct,  since  each  party  to  the  agreement  would 
wish  to  investigate  the  acts  of  his  agent.  As  Judge  Moore 
expressed  it:  "They  (the  tin-plate  manufacturers)  were  talk- 
ing originally  about  compensating  me  with  a  certain  amount 


^tTrrarv^ 


40  CORPOEATION  FINANCE 

of  stock,  but  I  could  not  handle  it  that  way.  I  had  to  buy 
the  properties  and  own  them,  and  handle  it  as  I  saw  fit." 
In  short,  the  promoter  in  organizing  his  $50,000,000  trust 
had  to  follow  methods  similar  to  those  which  were  employed 
to  organize  the  coal-mining  proposition.  He  was  obliged  to 
work  for  his  own  advantage,  to  "  fight  for  his  own  hand," 
throughout  the  transaction,  associating  members  of  the  trade 
with  himself  only  when  their  cooperation  was  necessary  to 
his  largest  success.  The  work  of  the  trust  promoter,  in  short, 
|WasNto  buy  plants  from  their  owners  at  one  price  and  sell 
I  them  to  the  investor  at  a  higher  price. 

His  first  step  was  to  estimate  the  probable  earning  power 
of  the  combination.  To  ascertain  this  earning  power,  the 
promoter  has  to  obtain  an  answer  to  two  questions:  (1) 
What  have  the  individual  plants  earned  for,  say,  the  past 
three  years?  and  (2)  how  much  will  those  earnings  be  in- 
creased by  combining  them  into  a  trust?  The  companies 
threw  their  books  open  for  inspection,  and  expert  accountants 
were  put  to  work  upon  them. 

The  first  question  could  be  fully  answered  by  taking  the 
statements  from  the  separate  companies  of  gross  receipts  and 
expenses.  Other  factors,  however,  must  be  considered,  most 
important  of  which  are  the  reserve  and  depreciation  accounts 
of  the  several  mills.  Here  is  one  company  which  charges 
the  cost  of  new  machinery  to  capital  account,  and  makes 
an  assessment  upon  its  stockholders  to  pay  for  all  machinery 
purchased.  Another  company  deducts  the  expense  of  ma- 
chinery from  its  net  receipts  before  dividends  are  declared. 
The  earnings  of  the  first  company.  Judging  from  the  sums 
dispersed  to  stockholders,  are  much  larger  than  those  of  the 
second  company,  while  in  reality  its  earnings  have  been  much 
smaller.  Another  company  may  be  ".  skinning  "  its  plant  by 
paying  large  dividends,  while  neglecting  to  keep  up  repairs. 
In  the  promoter's  estimates,  all  these  considerations  must  be 
taken  into  account.  He  must  reduce  the  earnings  of  all  the 
plants  to  a  common  denominator  of  identical  conditions. 

The  following  quotation  from  the  Iron  Age,  of  March 


THE   TRUST  41 

10,  1898,  illustrates  the  valuation  methods  of  conservative 
promoters :  "  J.  P.  Morgan  &  Company,  bankers,  some  time 
since  secured  options  on  the  plants  and  properties  of  a  num- 
ber of  iron  and  steel  producing  concerns  identified  with  the 
wire  rod  and  wire  interests  of  this  country  in  a  prominent 
way.  These  options  are  open  until  the  end  of  the  current 
month.  The  bankers  appointed  accountants  to  go  over  the 
books  of  the  different  concerns  during  the  last  three  years, 
to  ascertain  the  profits  in  each  year  and  the  average  profits 
of  the  past  three  years.  Expert  engineers  were  called  upon 
to  make  an  appraisal  of  the  plants  and  properties,  their  re- 
ports having  gone  in  some  time  since.  It  is  understood  that 
the  accountants,  pursuing  methods  of  their  own,  reached 
valuations  in  some  instances  considerably  below  those  estab- 
lished by  the  bookkeepers  of  the  companies  involved.  In  the 
majority  of  cases,  however,  the  options  were  considered  fair, 
and  are  reported  to  be  the  basis  of  the  settlement  on  the 
part  of  the  bankers.  It  is  a  fact,  however,  that  no  one  con- 
cern knows  the  price  to  be  paid  for  the  business  of  any  other 
company." 

The  second  part  of  the  promoter's  problem — to  estimate 
the  increased  earning  power  of  the  combination — is  more 
difficult  of  solution.  The  probable  increase  in  the  earning 
power  of  the  combined  plants  depends  upon  a  number  of 
factors,  some  of  which  are  known,  while  others  can  only  be 
guessed  at.  To  begin  with,  there  are  the  more  familiar 
economies  of  combination:  (1)  The  centralization  of  offices 
and  the  dismissal  of  a  number  of  high-priced  officials — for 
example,  one  engineer  of  tests  was  sufficient  in  the  eight  plants 
of  the  American  Locomotive  Company — and  this  enables  a 
considerable  reduction  of  general  expenses;  (2)  the  saving 
in  cross  freights — if  enough  trouble  be  taken  by  the  account- 
ants this  can  be  estimated  with  a  good  deal  of  accuracy; 
(3)  the  lower  rate  of  interest  on  discounts — the  price  of  time 
money  at  New  Castle,  Pennsylvania,  may  be  six  per  cent 
while  New  York  is  charging  only  font 'per"  cent -.on  equal 
security;  and  (4)   the  lower  prices  on  materials  secured  by 


42  COKPOKATION   FINANCE 


^ 


ordering  in  larger  quantities.  These  are  the  most  important 
of  the  economies  where  the  amount  saved  could  be  definitely 
ascertained. 

Beyond  this  restricte*d  field  of  certainty,  however,  lies  a 
vast  but  ill-defined  region  of  probability — the  savings  to  be 
achieved  by  the  centralization  of  management  and  the  elimi- 
nation of  competition.  How  much  can  be  gained  by  the 
regulation  of  prices,  by  the  increase  of  monopoly  power,  the 
closer  regulation  of  the  middleman,  the  reduction  in  the 
amount  of  bad  debts,  the  shortening  of  contracts  and.  credits, 
and  the  withdrawal  of  special  concessions?  How  much  will 
be  gained  by  the  increased  power  of  resistance  to  the  labor 
unions,  and  by  the  improved  position  of  the  combination  in 
dealing  with  railroads?  How  may  the  internal  economy  of 
the  organization  be  strengthened  by  the  continuous  opera- 
tion of  the  best  plants  during  periods  of  slack  demand,  by 
the  discharge  of  incompetent  officials  held  in  place  by  the 
influence  of  their  "  pull,"  by  the  thorough  testing  and  inspec- 
tion of  all  materials  purchased,  by  the  general  distribution 
of  the  special  knowledge  and  the  patented  processes  of  each 
plant,  by  the  opening  of  a  depreciation  account  on  the  books 
of  mills  to  which  it  has  been  a  stranger,  by  the  dis- 
placement of  old  and  worn-out  machinery  with  the  latest 
improvements,  and  by  the  inauguration  of  a  system  of  pro- 
motion to  stimulate  the  working  force  to  their  highest  effi- 
ciency? What  will  be  the  profit  from  the  broader  policy  of 
a  new  management;  from  the  concentration  of  production 
at  the  points  of  largest  advantage;  from  the  acquisition  of 
iron  mines,  coal  lands,  and  blast  furnaces  so  as  to  be  inde- 
pendent of  the  fluctuations  in  the  prices  of  materials;  from 
the  broader  market  for  the  securities  of  a  large  company  and 
the  resulting  facility  of  obtaining  capital  on  favorable  terms  ? 
And,  of  especial  importance  in  view  of  recent  developments 
in  international  trade,  what  will  be  the  profit  from  the  de- 
velopment of  the  world's  market? 

These  many  questions  could  not  be  answered  in  even  the 
roundest  of  numbers.     The  proposed  combination,  if  it  is 


THE   TEUST  43 

managed  with  intelligence,  would  increase  its  profits  by  each 
one  of  the  improvements  and  economies  suggested;  but  how 
much  is  impossible  to  discover.  The  promoter,  in  his  en- 
deavor to  estimate  the  economies  of  combination,  was  reduced 
to  elastic  approximations.  He  was  not  in  the  position  of 
the  coal  promoter,  the  elements  of  whose  problem  lay  in  his 
hand,  who  worked  with  known  conditions — the  cost  of  min- 
ing, the  profits  on  the  company's  store,  the  rates  of  freight, 
and  the  price  of  sale.  The  estimates  of  the  trust  promoter 
were  in  an  unknown  field.  His  calculations  were  at  best 
inaccurate  guesswork.  He  could  be  certain  only  of  so  much, 
that  the  profits  of  the  trust  would  be  much  larger  than  the 
combined  profits  of  the  companies  which  were  to  compose  it, 
and  of  this  profit  he  meant  to  secure  for  himself  the  largest 
possible  share. 

The  promoter,  having  estimated  the  profits  of  combina- 
tion, must  now  assemble  his  proposition;  he  must  acquire 
the  right  to  purchase  the  plants  which  he  desires  that  the 
new  corporation  should  Ov^rn.  To  this  end,  usually  with  the 
cooperation  of  manufacturers  who  were  well  known  in  the 
trade,  and  who  could,  if  necessary,  vouch  for  his  responsibility, 
besides  enforcing  his  arguments  by  their  own  representations, 
the  promoter  made  the  following  proposition  to  the  owners; 
that  they  should  sell  him  the  right  to  purchase  their  plants 
for  a  corporation  which  he  proposes  to  organize,  at  an  agreed 
price  and  for  a  definite  time.  The  capitalization  of  the 
proposed  company  was  to  be  fixed  at  the  amount  which  it 
was  believed  will  be  warranted  by  its  earnings,  increased,  as 
they  would  be,  over  the  combined  earnings  of  the  individual 
plants  by  the  economies  of  combination.  By  selling  their 
plants  to  the  new  company,  the  owners  could  either  (1) 
secure  a  sum  of  cash;  or  (2)  become  stockholders  or  bond- 
holders in  the  new  company  by  receiving  its  securities  in 
exchange  for  their  property;  or  (3)  sell  these  securities  and 
free  their  capital  for  other  uses. 

The  next  step  in  the  negotiations,  after  the  owners  had 
consented  to  sell,  was  to  determine  the  valuation  to  be  placed 


44  COEPOEATION   FmANCE  | 

upon  the  separate  properties.  It  was  here  that  the  promoter 
must  work  for  his  profits.  He  had  based  the  capitalization 
of  the  new  corporation  upon  his  estimate  of  the  earnings 
of  the  combined  plants.  The  securities  which  represented 
this  capitalization  he  expected  to  sell.  With  the  funds  re- 
ceived, he  would  take  up  his  options  and  equip  the  company 
with  the  necessary  working  capital.  What  remained  out  of 
the  proceeds  of  the  sale  is  the  promoter's  profit.  Expressed 
in  terms  of  securities,  this  was  the  difference  between  the 
total  amount  of  the  securities  of  the  consolidated  company 
and  the  amount  of  those  securities  given  in  exchange  for  the 
properties  and  the  cash  which  make  up  the  assets  of  the" 
consolidated  company.  It  was  the  promoter's  interest,  there-. 
fore,  to  bargain  shrewdly  with  the  owners  of  the  plants  which 
he  wished  to  purchase  in  order  to  reduce  the  amount  of  the 
stock  and  bonds  of  the  consolidation  which  he  must  sur- 
render to  acquire  these  plants.  His  situation  was,  in  general 
outline,  similar  to  the  situation  of  the  coal  promoter,  similar 
indeed  to  the  situation  of  every  promoter.  He  wished  to  buy 
something  cheap  and  sell  it  dear.  Keeping  this  principle 
in  mind,  it  is  unnecessary  to  do  more  than  to  sketch  in 
outline  the  methods  of  higgling  and  bargaining  which  were 
followed. 

The  promoter  usually  found  at  the  outset  that  he  had 
to  divide  his  expected  gains  with  some  of  the  owners  who 
were  already  associated  with  him  in  the  enterprise  and  with- 
out whose  cooperation  he  could  not  hope  to  succeed.  The 
bargains  which  he  made  with  these  men  were  not  hard.  They 
were  usually  large  manufacturers,  and  their  influence  and 
example  were  potent  in  persuading  others  to  enter  the  com- 
bination. The  high  figures  at  which  their  plants  were  put 
into  the  scheme  were  warranted,  if  not  by  the  value  of  the 
plants  themselves,  at  any  rate  by  the  advantage  which  the 
promoter  gained  from  their  cooperation.  Another  class  of 
owners  was  also  in  a  position  to  compel  the  promoter  to  give 
them  a  liberal  share  of  the  increased  value  of  combination. 
These  were  the  strong  firms  and  companies  who  have  been 


THE   TKUST  45 

making  money  even  under  competition,  and  who,  while  per- 
haps appreciating  to  the  fullest  extent  the  many  advantages 
of  combination,  realized  also  just  what  their  position  is  in 
the  trade,  and  how  important  it  was  to  the  success  of  the 
combination  that  their  plants  should  be  included  in  its  list 
of  assets.  If  strong  competitors  refuse  to  combine,  the  at- 
tractiveness of  the  proposition  was  much  diminished,  and 
unless  the  promoter  was  able  to  overcome  their  reluctance 
to  sell,  the  flotation  was  likely  to  fail. 

The  organization  of  the  Continental  Tobacco  Company, 
for  example,  was  delayed  several  months  until  terms  could 
be  made  with  Liggett  &  Meyers,  the  large  plug  tobacco  manu- 
facturers of  St.  Louis,  whose  competition  would  make  con- 
trol of  the  trade  very  doubtful.  During  the  progress  of  the 
negotiations,  Liggett  &  Meyers  gave  the  promoters,  who  also 
controlled  the  American  Tobacco  Company,  a  foretaste  of 
what  was  in  store  for  the  Continental  Company  if  organized 
without  them,  by  vigorously  fighting  the  American  Tobacco 
Company,  carrying  their  competition  even  to  the  point  of 
attempting  to  buy  all  the  best  tobacco  in  Kentucky,  and  so 
threatening  to  deprive  the  trust  of  its  advantages  in  purchas- 
ing raw  material.  The  outcome  of  this  struggle  was  that 
Liggett  &  Meyers  sold  out  to  the  Continental  Tobacco  Com- 
pany for  $12,500,000,  a  figure  representing  one  sixth  of  the 
total  capitalization  of  the  company.  Mr.  Carnegie's  success 
in  extorting  an  enormous  price,  estimated  at  over  $500,- 
000,000  for  the  securities  of  himself  and  his  partners,  is  a 
more  familiar  illustration  of  the  necessity  often  imposed 
upon  the  promoter  of  dividing  his  prospective  profits  with 
the  men  who  alone  can  make  those  profits  a  reality.  Every 
trust  promoter  has  had  similar  experiences.  These  valua- 
tions were  often  far  above  what  the  plants  were  worth  under 
competitive  conditions,  and  they  were  secured  only  because 
their  owners  knew  that  the  promoter  must  get  them,  no  matter 
at  what  sacrifice. 

If  this  scale  of  payment  were  to  be  kept  up,  the  promoter, 
after  the  equipment   of  his  company,  would  have  nothing 


46  cokpokaHS'ion  finance 

left  of  the  securities  with  which  he  started.  He  must  recover 
these  losses,  in  part  at  least,  from  the  owners  who  are  anxious 
to  sell.  They  had  been  hard  pressed  by  the  competitive 
struggle ;  they  might  be  advancing  in  years ;  their  plants  were 
often  under  mortgage  and  in  an  inferior  condition.  It  was 
impossible  that  they  could  find  purchasers  for  these  plants  as 
separate  concerns  for  more  than  a  small  fraction  of  the 
money  which  had  been  put  into  them.  To  men  in  such  a 
situation,  the  trust  offered  a  haven  of  refuge.  They  were 
glad  and  anxious  to  come  in  on  any  terms  that  would  re- 
lieve them  of  their  obligations,  and  leave  them  a  sum  of 
money  larger  than  could  be  secured  by  an  individual  sale. 
It  should  be  noted  in  this  connection  that  the  salability  of 
a  mill  is  much  increased  by  combining  it  with  twenty  other 
mills  in  the  same  line  of  production  and  disposing  of  it 
through  the  stock  market.  Before  consolidation,  the  demand 
for  a  small  property  was  narrow  and  uncertain.  As  a  part 
of  the  trust,  however,  the  demand  was  furnished  by  the 
speculative  public  of  the  entire  country.  It  is  also  to  be 
observed  that  the  prospect  of  being  left  outside  the  combi- 
nation served  to  moderate  the  demands  of  those  who  dis- 
trusted their  ability  to  resist  such  powerful  competition. 
The  promoter  could,  in  a  measure,  recover  from  the  majority 
of  manufacturers  who  are  in  the  position  just  described,  the 
advantage  which  he  was  compelled  to  sacrifice  to  the  more 
important  members  of  the  trade. 

By  one  means  and  another,  by  alliance,  persuasion,  and 
coercion,  the  promoter  had  assembled  his  proposition.  All 
the  plants  which  he  considers  necessary  to  the  trust  were 
under  his  control.  He  had  options  upon  an  entire  industry, 
which,  when  exercised,  would  place  a  single  corporation  in 
control  of  that  industry,  in  this  way  eliminating  competition 
and  increasing  earning  power. 


i 


■^- 


/{-f  ^  4 


CHAPTER   IV 
MATERIALS  OF  THE  FINANCIAL  PLAN 

Our  promoter  has  now  proceeded  in  the  flotation  of  his 
enterprise  as  far  as  he  can  go  without  assistance.  He  must 
now  obtain  money  to  take  up  his  options,  build  his  factory  or 
railroad,  and  inaugurate  his  enterprise.  He  may  obtain 
this  money  from  the  investing  public  to  whom  his  appeal 
may  be  made  directly,  by  published  advertising,  circular 
letters  and  agents.  If  the  nature  of  his  proposition  per- 
mits, he  will  present  it  to  banker^  and  ask  them  to  pur- 
chase, or  to  agree  to  purchase,  a  sufficient  amount  of  the 
securities  of  his  new  company  to  provide  it  with  the  money 
which  it  requires.  In  the  United  States  it  is  a  safe  con- 
clusion that  in  nearly  all  cases  where  the  character  of  the 
proposition  is  such  as  to  appeal  eventually  to  the  conser- 
vative investor,  the  promoter  will  approach  bankers  and  en- 
deavor to  secure  from  them  the  funds  which  the  new  com- 
pany requires.  The  bankers  will  purchase  the  securities  with 
the  expectation  of  selling  them  to  the  public,  but,  for  the 
time  being,  the  dealings  are  between  the  promoter  and  the 
banker. 

A  company  has  been  incorporated  which  will  hold  title 
to  the  property  with  whose  acquisition  the  promoter  has 
occupied  himself.  This  corporation  will  issue  certain  secur- 
ities. These  securities  will  be  sold  to  the  investor  who  will, 
in  this  way,  furnish  the  money  for  the  development  of  the 
enterprise.  The  preparation  of  the  financial  plan  is  there- 
fore the  next  step.  \ 

A  corporation  is  an  association  of  individuals  authorized  f 

47 


48  COKPOBATION   FINANCE 

f 

by  law  to  own  property,  to  contract  debt,  to  appoint  officers 
and  agents,  and  to  manage  its  business  within  the  limits  of 
the  formal  grant  of  authority  by  the  state,  which  is  known 
as  its  charter,  in  all  respects  as  though  it  were  a  natural 
person.  The  association,  it  will  be  remarked,  owns  the  prop' 
erty.  It  is  represented  in  its  management  of  the  business 
of  the  company  by  trustees  called  directors.  These  trustees, 
in  turn,  appoint  officers  who  carry  on  most  of  the  work  of 
business  management. 

The  ownership  in  the  association  is  called  the  "  stock " 
of  the  corporation  and  this  stock  is  divided  into  shares.  It 
is  the  custom  to  represent  this  stock  ownership  in  a  company 
by  a  certain  arbitrarily  assumed  sum,  such  as  $500,000  or 
$1,000,000,  or,  in  the  case  of  the  original  capitalization  of 
the  United  States  Steel  Corporation,  $1,100,000,000.  This 
capitalization,  as  the  expression  of  ownership  in  the  company, 
is  divided  into  shares,  each  of  which,  being  a  proportionate  part 
of  the  total  capitalization,  represents  an  assumed  sum  of 
money.  This  assumed  sum  is  known  as  their  par  value.  If 
the  capital  of  the  company,  for  example,  is  $100,000  and  is 
divided  into  1,000  shares,  then  the  assumed  or  par  value  of 
each  share  would  be  $100.  Since  it  is  in  this  form  that  the 
ownership  of  business  corporations  is  expressed,  the  first  step 
in  the  preparation  of  the  financial  plan  is  to  fix  upon  a  certain 
capitalization  which  shall  represent  the  ownership  in  the 
company.  The  considerations  affecting  the  amount  of  this 
capitalization  will  presently  appear. 

These  shares  of  ownership  may  be  sold  to  provide  funds 
for  the  company.  In  private  companies,  such  as  manufactur- 
ing or  trading  companies,  this  is  the  usual  method.  The 
company  is  capitalized  for  the  amount  of  money  which  is 
immediately  required,  and  those  who  desire  to  participate  in 
the  enterprise  purchase  varying  amounts  of  stock.  The 
rights  of  the  holders  of  these  shares  are:  (1)  to  vote  for 
directors  of  the  company,  and  on  all  propositions  which  the 
charter  provides  shall  be  submitted  to  a  vote  of  the  stock- 
holders— for  example,  the  sale  of  the  property  of  the  com- 


MATERIALS    OF   THE   FINANCIAL  PLAN       49 

pany  or  its  dissolution;  (2)  to  be  faithfully  represented  by 
these  trustees  or  directors;  (3)  to  participate*  in  the  profits 
of  the  company,  when  the  directors  decide  that  these  profits 
have  been  earned,  and  that  it  is  expedient  to  distribute  them ; 
and  (4)  to  share  in  the  proceeds  of  the  assets  of  the  com- 
pany in  case  of  dissolution  or  liquidation.  These  rights 
of  the  stockholder  are  set  down  in  detail  in  the  certificate 
of  incorporation  or  charter.  The  incorporators  themselves 
draw  up  this  certificate  under  the  general  incorporation  law 
of  the  State.  When  duly  authenticated,  recorded  and  filed 
with  the  proper  official,  it  becomes  the  charter  of  the  com- 
pany, the  evidence  of  its  right  to  be  a  corporation,  the  fun- 
damental contract  between  the  State  and  the  corporation, 
between  the  corporation  and  its  stockholders,  and  between 
the  stockholders  themselves,  a  contract  which  cannot  be 
changed  without  the  unanimous  consent  of  every  stockholder. 
In  but  few  cases  can  a  public  business  corporation  be 
financed  in  such  a  simple  manner.  When  the  appeal  is  made 
to  the  public  to  supply  the  funds,  a  more  elaborate  financial 
plan  must  be  devised.  It  is  customary  to  divide  the  stock 
into  two  classes:  preferred  stock  and  common  stock,  or,  as 
the  English  describe  it,  ordinary  stock.  Preferred  stock  has 
preference  in  the  distribution  of  profits,  and,  if  provided  in 
the  charter,  preference  in  any  distribution  of  the  assets  of 
the  company  to  stockholders.  If  a  company  issues  50,000 
shares,  the  owner  of  5,000  shares  is  the  proprietor  of  one 
tenth  of  the  corporation.  In  the  absence  of  some  special 
provision  to  the  contrary,  he  can  exercise  one  tenth  of  the 
voting  power.  If  the  directors  declare  a  dividend  out  of 
the  profits  of  the  company,  this  distribution  is  made  to  the 
stockholders  on  the  basis  of  the  number  of  shares  held  by 
each.  For  example,  if  the  sum  distributed  is  $50,000,  the 
holder  of  5,000  shares  would  receive  $5,000.  If  the  company 
is  dissolved  and  its  assets  bring  $500,000,  the  holder  of  5,000 
shares  would  receive  $50,000.  This  would  apply,  no  matter 
what  the  capitalization  of  the  company  might  be,  or  into 
how  many  shares  it  might  be  divided.     Whether  the  capital- 


50  CORPOKATION   FINANCE 

ization  is  $5,000,000,  or  $50,000,  or  the  par  value  $100,  or 
$1,  the  position  of  the  stockholder  in  participating  in  divi- 
dends and  in  assets  is  the  same. 

This  holds  true  if  only  one  class  of  stock  is  issued.  If 
preferred  stock  is  issued,  two  classes  of  owners  are  created: 
First,  preference  shareholders,  who  receive  a  certain  rate  of 
dividends,  usually  seven  per  cent  on  the  par  value  of  their 
shares,  which  must  be  paid  them  out  of  any  profits  distributed 
before  the  holders  of  any  of  the  common  stock  can  receive 
anything;  second,  common  stockholders,  who  take  what  is 
left  after  the  claims  of  preferred  stockholders  have  been 
satisfied.  The  advantage  of  the  preferred  stockholder  is  that 
he  has  a  prior  claim  upon  the  profits  of  the  company,  a  claim 
inferior,  it  is  true,  to  that  of  the  creditor,  but  which  takes 
precedence  of  the  common  stockholder.  If  the  profits  of  the 
company  are  only  sufficient  to  pay  seven  per  cent  on  the  par 
value  of  the  shares,  if  this  amount  is  called  for  in  his  pre- 
ferred stock  contract  with  the  corporation,  and  in  case  the 
directors  decide  to  distribute  these  profits,  the  preferred  stock- 
holder will  receive  his  seven  per  cent,  while  the  common 
stockholder  will  receive  nothing.  It  may  also  be  provided  in 
the  contract  between  the  corporation  and  the  preferred  stock- 
holder that  he  shall  participate  equally  with  the  common 
stockholder  in  any  distribution  of  profits,  until  a  certain 
additional  amount  of  return  on  the  preferred  stock  has  been 
paid;  or  this  participation  with  the  common  stock  may 
begin  after  a  certain  dividend  has  been  paid  on  the  stock, 
after  which  both  classes  of  stock  share  equally  in  profits; 
or  the  participation  of  the  preferred  stock  may  be  unlimited 
from  the  beginning. 

Preferred  stock  may  be  classified  into  cumulative  and 
noncumulative  preferred  stock.  In  the  charters  of  companies 
issuing  preferred  stock,  .the  following  provision  is  usually 
found:  "The  dividends  upon  the  preferred  stock  shall  be 
cumulative  so  that  if,  in  any  year,  the  dividends  amounting 
to  seven  per  cent  per  annum,  are  not  paid  on  the  preferred 
stock,  the  deficiency  is  payable  subsequently  before  any  divi- 


MATERIALS    OF   THE   FINANCIAL  PLAN       51 

dends  are  set  apart  or  paid  on  the  common  stock."  If  the 
earnings  of  a  corporation  in  a  certain  year  are  only  sufficient 
for  the  distribution  of  $1,500,000,  while  the  dividend  of 
seven  per  cent  on  the  preferred  stock  calls  for  a  distribution 
of  $2,000,000,  in  the  following  year,  the  preferred  stock- 
holders, in  addition  to  their  regular  dividends  of  $2,000,000, 
must  receive  the  $500,000  of  dividends  which  they  failed  to 
get  in  the  preceding  year  before  the  common  stock  can  re- 
ceive any  dividend.  No  matter  to  what  sum  these  unpaid 
dividends  on  the  preferred  stock  may  amount,  all  these  back 
dividends  must  be  paid  in  some  form  to  the  preferred  stock- 
holder before  the  common  stockholders  receive  anything. 

Preferred  stock  may  be  divided  into  series  according  to 
the  order  of  preference  as  first,  second,  and  third  preferred. 
This  arrangement  is,  however,  uncommon.  Preference  may  be 
given  the  preferred  stockholder  in  assets  as  well  as  earnings 
by  providing  that,  in  the  event  of  a  dissolution  of  the  com- 
pany, and  a  sale  of  its  assets,  the  par  value  of  the  preferred 
stock  shall  first  be  paid  to  its  stockholders  before  anything 
is  paid  on  the  common  stock. 

The  final  form  of  security,  utilized,  as  a  rule,  wherever 
possible  in  the  preparation  of  a  financial  plan,  is  the  bond. 
Corporation  bonds  are  promissory  notes,  usually  in  denomi- 
nations of  $500  or  $1,000,  and  as  evidences  of  the  same  debt, 
$1,000,000,  $50,000,000,  or  $300,000,000,  as  the  case  may  be. 
The  evidences  of  these  large  debts  are  issued  in  a  number 
of  notes,  in  order  that  they  may  be  readily  marketed.  A 
corporation  wishing  to  borrow  $1,000,000  for  thirty  years  on 
the  best  security,  would  have  great  difficulty  in  placing  the 
entire  loan  with  a  single  investor.  No  matter  how  good  may 
be  the  security,  few  investors  have  sufficient  funds  to  make 
a  loan  of  this  amount,  and  the  few  whose  resources  are  suf- 
ficient are  likely  to  have  other  uses  for  their  money.  By 
issuing,  instead  of  one  note  for  $1,000,000,  one  thousand 
notes  of  $1,000  each,  the  corporation  is  able  to  draw  upon 
the  funds  of  a  large  number  of  investors,  who  may  buy  its 
thirty  year  notes,  in  lots  of  one,  five  or  fifty. 


52  COEPOKATION  FINANCE 

These  notes  are  usually  secured  as  an  entirety,  by  a  mort- 
gage, the  relation  of  each  to  the  security  being  the  same  as 
every  other.  A  mortgage  is  a  written  instrument  for  the^ 
conveyance  of  real  or  personal  property  by  a  debtor  to  the  \ 
creditor  or  his  representative  to  insure  the  performance  by 
the  debtor  of  his  promise  to  pay  interest  and  principal.  The 
possession  of  the  property  may  remain  with  the  debtor,  and 
this  is  the  rule  when  real  property  is  pledged,  or,  as  is 
usually  done  with  personal  property  such  as  shares  of  stock 
pledged  as  security  for  a  loan,  the  actual  property  may  be 
turned  over  to  the  lender's  representative  or  trustee,  usually 
a  trust  company. 

The  form  of  a  bond  is  as  follows: 


(FOEM   OF   COUPON   BOND.) 

UNITED   STATES    OF   AMEKICA, 

State  of  New  York. 
No.  100  $500.00 

THE    LONG    ISLAND    KAILEOAD    COMPANY. 

Four  Per  Cent  Eefunding  Mortgage  Gold  Bond, 
Due  March  1,  1949. 

THE  LONG  ISLAND  EAILEOAD  COMPANY," 

a  corporation  organized  and  existing  under  and  pur- 
suant to  the  laws  of  the  State  of  New  York,  for  value 
received,  hereby  promises  to  pay  to  the  bearer,  or,  if 
this  bond  be  registered,  then  to  the  registered  owner 
hereof,  at  its  financial  agency  in  the  Borough  of  Man- 
hattan, in  the  City  and  State  of  New  York,  500  dol- 
lars in  gold  coin  of  the  United  States  of  America,  of  or 
equal  to  the  present  standard  of  weight  and  fineness,  on 
the  first  day  of  March  in  the  year  nineteen  hundred 
and  forty-nine,  and  to  pay  interest  thereon  at  the  rate 
of  four  per  cent  per  annum,  from  the  first  day  of  Sep- 


MATERIALS    OF   THE   FINANCIAL  PLAN        53 

tember,  nineteen  hundred  and  three,  in  like  gold  coin, 
semi- annually,  on  the  first  days  of  March  and  Sep- 
tember in  each  year,  upon  presentation  and  surrender 
at  its  agency  aforesaid  of  the  coupons  hereto  annexed 
as  they  severally  become  due  and  until  said  principal 
sum  is  paid.  Both  the  principal  and  interest  of  this 
bond  are  payable  without  deduction  for  any  tax  or 
taxes  which  the  Railroad  Company  may  be  required 
to  pay  or  retain  therefrom  under  any  present  or  future 
law  of  the  United  States  or  of  the  State  of  New  York. 
This  bond  is  one  of  a  series  of  bonds  of  like  date 
and  tenor,  of  the  denomination  of  five  hundred  dollars 
or  multiples  thereof,  known  as  Four  Per  .Cent  Refund- 
ing Mortgage  Gold  Bonds,  issued  and  to  be  issued  to 
an  amount  not  exceeding  in  the  aggregate  the  principal 
sum  of  forty-five  million  dollars  at  any  one  time  out- 
standing, all  of  which  bonds  are  issued  and  to  be  issued 
under  and  equally  secured  by  a  mortgage  and  deed  of 
trust  dated  September  1,  1903,  executed  by  THE 
LONG  ISLAND  RAILROAD  COMPANY  to  THE 
EQUITABLE  TRUST  COMPANY  OF  NEW  YORK 
as  Trustee,  to  which  mortgage  and  deed  of  trust  refer- 
ence is  made  for  a  description  of  the  properties  and 
franchises  mortgaged,  the  nature  and  extent  of  the 
security,  the  rights  of  the  holders  of  bonds  under  the 
same,  and  the  terms  and  conditions  upon  which  the 
bonds  are  issued  and  secured. 

IN  WITNESS  WHEREOF,  The  Long  Island 
Railroad  Company  has  caused  its  corporate  seal  to 
be  hereunto  affixed  and  attested  by  its  Secretary  or 
Assistant  Secretary,  and  this  bond  to  be  signed  in  its 
corporate  name  by  its  President  or  Vice-President, 
and  has  also  caused  the  signature  of  its  Treasurer  to 
be  engraved  upon  the  annexed  coupons,  as  of  the  first 
day  of  September,  in  the  year  one  thousand  nine 
hundred  and  three. 

THE    LONG   ISLAND   RAILROAD    COMPANY, 
By 

President. 
Attest : 

Secretary. 


54  CORPORATION   FINANCE 

(FORM    OF    COUPON.) 
No.  100  $10.00 

THE  LONG  ISLAND  RAILROAD  COMPANY 
will  pay  to  the  bearer  at  its  financial  agency  in  the 
City  of  New  York,  on  the  first  day  of  March,  ten 
dollars  ($10.00)  in  gold  coin,  being  six  months'  inter- 
est then  due  on  its  Four  Per  Cent  Refunding  Mortgage 
Gold  Bond  Number  100. 

Treasurer. 

This  bond  or  promissory  note  refers  to  a  certain  mortgage 
executed  to  the  Equitable  Trust  Company  of  New  York  by 
the  borrowing  company,  for  the  equal  securing  of  all  the 
bonds,  ninety  thousand  in  number,  into  which  this  loan  is 
divided.  This  mortgage  describes  in  detail  the  property  of 
the  company  set  aside  for  the  securing  of  its  bonds,  and 
transfers  it  to  the  trustee,  in  the  following  granting  clause :  ^ 

That  in  order  to  secure  the  payment  of  the  principal 
and  interest  of  all  said  bonds  at  any  time  issued  and 
outstanding  under  this  indenture,  according  to  their 
tenor,  purport  and  effect,  and  to  secure  the  perform- 
ance and  observance  of  all  the  covenants  and  con- 
ditions herein  contained,  and  to  declare  the  terms 
and  conditions  upon  which  said  bonds  are  issued, 
received  and  held,  and  for  and  in  consideration  of 
the  premises  and  of  the  acceptance  or  purchase  of  said 
bonds  by  the  holders  thereof,  and  of  the  sum  of 
one  hundred  dollars,  lawful  money  of  the  United 
States  of  America,  to  it  fully  paid  by  the  Trustee 
on  or  before  the  ensealing  and  delivery  of  these 
presents,  the  receipt  whereof  is  hereby  acknowledged. 
The  Long  Island  Railroad  Company,  the  party  of  the 
first  part,  has  granted,  bargained,  sold,  aliened,  re- 
leased, conveyed,  assigned,  transferred  and  set  over, 
and  by  these  presents  does  grant,  bargain,  sell,  alien, 
release,  convey,  assign,  transfer  and  set  over  unto 
the  said  Trustee  and  its  successors  in  the  trust  hereby 
created,  all  and  singular  the  railroad  and  ferry  prop- 

^  Detailed  provisions  for  registration  omitted. 


MATERIALS    OF   THE   FINANCIAL  PLAN       55 

erty,  and  other  property,  real  and  personal,  used  in 
connection  with  such  railroad  and  ferry  property,  and 
franchises  of  every  kind  relating  thereto  or  exer- 
cisable in  connection  therewith,  of  the  Railroad  Com- 
pany, including  the  following,  to  wit :  ^ 

(A  detailed  description  of  the  property  follows.) 
This  grant,  however,  is  not  absolute,  but  conditional.  If 
the  borrowing  company  performs  its  obligations  to  pay  prin- 
cipal and  interest,  and,  as  we  shall  show  hereafter,  to  con- 
serve the  security  of  the  bonds,  then  the  grant  lapses.  It  is 
made  for  a  specific  purpose,  namely  the  securing  of  the  bonds, 
and  when  the  bonds  have  been  paid,  the  purpose  has  been 
accomplished,  and  the  title  to  the  pledged  property  reverts 
to  its  owner  who  is,  moreover,  so  long  as  he  lives  up  to  his 
obligations,  allowed  to  remain  in  undisturbed  possession.  The 
clauses  of  the  mortgage  governing  these  matters  are  as  fol- 
lows :  First,  the  "  Habendum  '^  clause : 

TO    HAVE    AND    TO    HOLD    all    and    singular 

the  above  mentioned  and  described  railroads,  rail- 
road property,  ferries,  ferry  property,  franchises,  real 
estate  and  personal  property  unto  the  said  The  Equit- 
able Trust  Company  of  New  York,  as  Trustee,  its 
successors  and  assigns  forever. 

BUT  IN  TRUST,  NEVERTHELESS,  for  the 
equal  and  proportionate  benefit  and  security  of  all 
holders  of  the  bonds  and  coupons  issued  and  to  be 
issued  under  and  secured  by  this  indenture,  and  for 
the  enforcement  of  the  payment  of  said  bonds  and 
interest,  when  payable,  according  to  the  tenor,  purpose 
and  effect  of  such  bonds  and  coupons,  and  to  secure 
the  performance  and  observance  of  and  compli-  ■ 
ance  with  the  covenants  and  conditions  of  this  in- 
denture, without  preference,  priority  or  distinction, 
as  to  lien  or  otherwise,  of  one  bond  over  any  other 
bond  by  or  by  reason  of  the  purpose  of  itg  issue, 
so  that  each  and  every  bond  issued  or  to  be  issued  here- 
under shall  have  the  same  right,  lien  and  privilege 

*  Italics  are  the  author's. 


56  CORPORATION  FINANCE 

under  and  by  virtue  of  this  indenture,  and  so  that 
the  principal  and  interest  of  every  such  bond  shall, 
subject  to  the  terms  hereof,  be  equally  and  proportion- 
ately secured  hereby  as  if  all  had  been  duly  issued, 
sold  and  negotiated  simultaneously  with  the  execu- 
tion and  delivery  hereof.^ 

Article  Seventeenth. — ^If,  when  the  bonds  hereby 
secured  shall  have  become  due  and  payable,  the  Rail- 
road Company  shall  well  and  truly  pay  or  cause  to  be 
paid  the  whole  amount  of  the  principal  and  interest 
due  upon  all  of  the  bonds  hereby  secured  then  out- 
standing, or  shall  provide  for  such  payment  by  de- 
positing with  the  Trustee  hereunder,  for  the  pay- 
ment of  such  bonds  and  interest  thereon,  the  entire 
amount  due  or  to  become  due  for  principal  and 
interest,  and  shall  also  pay  or  cause  to  be  paid  all 
other  sums  payable  hereunder  by  the  Railroad  Com- 
pany and  shall  well  and  truly  keep,  perform  and 
observe  all  the  things  herein  required  to  be  kept, 
performed  and  observed  by  it  according  to  the  true 
intent  and  meaning  of  this  indenture,  then  and  in 
that  case  the  premises  and  all  properties,  rights  and 
interests  hereby  conveyed  shall  revert  to  the  Rail- 
road company,  or  to  whoever  may  be  entitled  thereto, 
and  the  estate  right,  title  and  interest  of  the  Trustee 
therein  shall  thereupon  cease,  determine  and  become 
void ;  and  the  Trustee  shall,  in  such  case,  on  demand  of 
the  Railroad  Company  and  at  its  cost  and  expense,  en- 
ter satisfaction  and  discharge  of  this  indenture  upon 
the  records;  otherwise,  the  same  shall  be,  continue 
and  remain  in  full  force  and  virtue. 

In  addition  to  promising  to  pay  the  principal  and  inter- 
est, the  railway  company  enters  into  a  number  of  agree- 
ments which  are  designed  to  maintain  the  security  of  the 
bonds  intact.     Some  of  these  covenants  are  as  follows:  to 

*  The  right  of  the  railway  company  to  remain  in  possession  of  the 
property  is  not  expressly  stated  in  this  mortgage  but  is  implied  from 
numerous  clauses.  This  conveyance  of  its  property  by  a  company  to 
the  trustee  is  not  in  perpetuity.  When  the  obligations  of  the  bonds  are 
discharged  the  property  reverts  to  the  company. 


MATEKIALS   OF   THE   FINANCIAL  PLAN       57 

pay  all  taxes,  to  keep  the  property  in  repair,  and  to  perform 
all  the  obligations  of  the  franchises  and  leases  under  which 
the  lines  of  the  system  are  operated.  Failure  to  perform  any 
of  these  covenants  would  evidently  impair  the  value  of  the 
security  underlying  the  bonds. 

In  case  the  railway  company  defaults  in  the  payment  of 
principal  or  interest,  or  fails  to  perform  any  of  the  covenants 
into  which  it  has  entered  for  the  protection  of  the  bond- 
holder, the  mortgage  provides  that  the  Trustee  may  either 
enter  upon  the  property  and  operate  it  for  the  benefit  of 
creditors,  or  sell  the  property  and  apply  the  proceeds  of  the 
sale  to  the  payment  of  the  company's  debts,  returning  any 
balance  which  may  remain  to  the  company.  The  company 
agrees  not  to  interpose  any  obstacle  or  objection  to  the  enforce- 
ment of  the  bondholders'  rights  by  the  Trustee. 

The  purpose  and  efi'ect  of  this  mortgage  is  to  set  apart 
certain  property  of  the  company  for  the  protection  of  its 
creditors  should  it  default  on  any  of  its  obligations,  and  to 
provide  a  method  by  which  the  representatives  of  the  credi- 
tors may  take  possession  of  this  property  when  default  oc- 
curs, and  apply  its  income  or  the  proceeds  of  its  sale  to 
the  payment  of  the  company's  debts.  The  company,  in  effect, 
says  to  its  creditors :  "  We  appoint  you  or  your  representative, 
our  trustee,  to  pay  our  debts  in  the  event  that  we  are  unable 
to  pay  them.  In  order  that  you  may  discharge  your  trust, 
we  place  in  your  hands  certain  property  with  the  stipula- 
tion that  as  long  as  we  perform  our  obligations  we  may  be 
allowed  to  use  the  property  as  our  own.  Should  we  fail, 
however,  in  the  performance  of  any  of  these  obligations, 
then  you,  our  trustee,  are  to  sell  the  property  and  so  dis- 
charge the  obligation  of  your  trust." 

These  mortgages  may  be  of  various  grades,  first,  second, 
and  third  mortgages,  all  resting  upon  the  same  property, 
differing  from  each  other  in  the  relative  superioriH:y  of  their 
liens.  Thus  the  bonds  secured  by  the  lien  of  a  second  mort- 
gage, if  the  company  defaults  on  their  interest,  cannot  en- 
force their  claim  by  seizing  and  selling  its  property,  until 


58  COEPORATION   FINANCE 

they  have  first  satisfied  the  claim  of  the  holders  of  the  first 
mortgage  bonds,  or,  if  they  sell  the  property,  they  must  sell 
it  subject  to  this  first  mortgage  lien.  Except  during  a 
receivership,  as  will  be  explained  hereafter,  as  long  as  the 
bonds  which  the  first  mortgage  secures  are  in  existence, 
the  property  of  the  company  can  in  no  way  be  separated 
from  the  lien  of  the  first  mortgage.  In  the  same  way, 
the  lien  of  a  third  mortgage  is  inferior  to  that  of  a  second 
mortgage. 

The  nature  of  a  mortgage  as  a  conveyance  of  property 
appears  more  clearly  in  a  collateral  trust  mortgage,  where 
the  security  of  the  bonds  consists  of  the  stocks  or  bonds  of 
other  corporations.  Under  these  mortgages,  not  merely  the 
title,  but  the  physical  possession  of  the  property  passes  to 
the  Trustee.  For  example,  the  Trust  Indenture  securing  the 
bonds  issued  jointly  in  1901  by  the  Great  Northern  and  the 
Northern  Pacific  Eailroad  Companies,  secured  by  the  stock  of 
the  Chicago,  Burlington  &  Quincy,  provides : 

That,  in  order  to  secure  the  payment  of  the  prin- 
cipal and  interest  of  all  such  bonds  at  any  time  is- 
sued and  outstanding  under  this  indenture,  and  the 
performance  of  all  the  covenants  and  conditions  herein 
contained,  and  in  consideration  of  the  premises  and  of 
the  purchase  and  acceptance  of  such  bonds  by  the 
holders  hereof,  and  of  the  sum  of  one  dollar  to  each 
of  them  duly  paid  by  the  Trustee  at  the  ensealing 
and  delivery  of  these  presents,  the  receipt  whereof 
is  hereby  acknowledged,  the  Railway  Companies, 
parties  of  the  first  part,  have  assigned  and  transferred, 
and  by  these  presents  do  assign  and  transfer  unto 
the  Trustee,  party  of  the  second  part,  its  successors 
and  assigns,  one  million  and  sixty-six  thousand  and 
six  hundred  (1,066,600)  shares  of  the  capital  stock 
of  the  Chicago,  Burlington  &  Quincy  Railroad  Com- 
pany the  certificates  for  which  have  been  delivered 
to  the  Trustee,  and  all  additional  shares  of  the  cap- 
ital stock  of  said  Company  in  exchange  for  which 
bonds  hereby  secured  shall  be  certified  and  delivered 
hereunder. 


MATEKIALS   OF   THE   FINANCIAL  PLAN       59 
TO  HAVE   AND   TO  HOLD  the  said  shares  of 


capital  stock,  and  all  additional  property  that  here- 
after shall  become  subject  to  this  indenture  unto  the 
Trustee  and  its  successors  and  assigns,  in  trust  for 
the  equal  and  proportionate  security  of  all  present  and 
future  holders  of  bonds  and  interest  obligations  issued, 
and  to  be  issued,  under  and  secured  by  this  indenture, 
and  for  the  enforcement  of  the  payment  of  said  bonds 
and  interest  obligations  when  payable,  and  the  per- 
formance of  and  compliance  with  the  covenants  and 
conditions  of  this  indenture,  without  preference,  prior- 
ity or  distinction  as  to  lien  or  otherwise  of  any  one 
bond  over  any  other  bond  by  reason  of  priority  in 
the  issue  or  negotiation  thereof. 

If  any  default  should  occur  on  the  part  of  the  borrow- 
ing Companies,  the  Trustee  is  authorized  to  sell  the  shares 
of  stock  securing  the  bonds,  and  to  proceed  against  the  Great 
Northern  and  the  Northern  Pacific  for  the  recovery  of  any 
balance  which  may  remain  after  the  Trustee  applies  the  pro- 
ceeds of  the  sale  to  the  payment  of  the  bonds.  As  long, 
however,  as  the  borrowing  companies  carry  out  the  conditions 
and  covenants  of  the  mortgage,  the  Trustee  empowers  the 
company  issuing  the  stock  which  he  holds  in  pledge,  the 
Chicago,  Burlington  &  Quincy,  to  pay  to  the  owners  of 
the  stock,  the  Great  Northern  and  the  Northern  Pacific,  the 
dividends  on  the  stock,  and  issues  to  them  his  power  of 
attorney,  or  proxy,  which  will  authorize  them  to  vote  the 
stock  as  though  the  certificates  representing  it  were  in  their 
possession,  and  they  appeared  as  the  registered  owners  of 
the  stock  on  the  books  of  the  Chicago,  Burlington  &  Quincy. 
In  case  of  any  default,  however,  the  Trustee  immediately 
resumes  these  delegated  rights  of  ownership,  and  the  two 
borrowers  lose  their  right  to  vote  the  Burlington  stock  and 
to  receive  dividends. 


CHAPTER   V 
THE  ISSUING  OF  SECURITIES 

We  have  now  described  the  ordinary  securities  which  our 
new  company  may  issue  to  obtain  the  money  required  to  con- 
struct its  plant.  Our  next  topic  is  the  methods  by  which 
these  securities  are  prepared  and  included  in  a  plan  of  cap- 
italization, for  sale  to  bankers  or  to  the  public. 

In  taking  up  the  considerations  which  the  banker  and 
promoter  must  have  in  mind  in  preparing  a  financial  plan, 
we  note  first  that  their  chief  concern  is  to  obtain  the  neces- 
sary money  on  the  easiest  terms.  Up  to  the  point  of  provid- 
ing the  money,  their  interests  are  united.  It  is  only  when 
the  division  of  the  profits  is  reached  that  they  part  company. 
We  have  now  to  consider  the  choice  of  securities  of  which  the 
capitalization  of  the  new  company  is  to  consist.  These  are, 
as  we  have  seen,  stock  of  various  kinds,  and  bonds  with  various 
kinds  of  security. 

As  a  rule,  whenever  the  enterprise  admits,  the  financial 
plan  will  call  for  the  issue  of  bonds,  and  if  that  fails,  for 
the  issue  of  preferred  stock.  The  reason  for  preferring  this 
method  of  borrowing  lies  in  the  nature  of  a  bond.  The 
purchaser  of  a  corporation  bond,  in  return  for  what  he  con- 
siders to  be  suflRcient  security  of  income  and  principal,  sur- 
renders his  right  to  participate  in  the  profits  of  the  company 
above  the  moderate  rate  of  interest  named  in  his  bond,  four, 
five  or  six  per  cent.  With  the  preferred  stockholder,  the  situ- 
ation is  the  same.  In  return  for  a  preferred  claim  to  a  fixed 
rate  of  dividend,  the  preferred  stockholder,  unless  his  stock 
is  participating,  surrenders  the  remainder  of  the  dividends 
60 


THE   ISSUING   OF   SECURITIES  61 

to  the  common  stock.  If,  therefore,  in  the  financial  plan, 
all,  or  a  large  part  of  the  money  necessary,  can  be  secured 
by  selling  bonds,  and  if  the  expectations  of  the  promoters 
that  large  profits  will  be  earned  are  realized,  it  is  more  profit- 
able to  employ  this  method. 

Suppose,  for  example,  that  $1,000,000  is  required  to  carry 
through  the  consolidation,  or  build  the  plant,  or  construct 
the  railroad,  and  that  the  earnings  of  the  enterprise  will  be 
at  the  rate  of  twelve  per  cent  or  $120,000  annually.  Sup- 
pose, further,  that  this  money  can  be  raised  either  by  the 
sale  of  bonds,  or  by  the  sale  of  stock,  or  that  both  methods 
can  be  used  in  combination.  If  $1,000,000  can  be  provided 
ty  the  sale  of  bonds  bearing  six  per  cent  interest,  the  pro- 
moters and  bankers  will  have  common  stock  which  can  share 
earnings  of  $60,000  a  year,  after  paying  interest  on  the  cost 
of  the  property,  and  for  this  stock  they  may  have  paid  noth- 
ing, except  the  cost  of  securing  the  options  and  selling  the 
securities.  Their  stock  is  all  "  velvet."  Although  they  may 
have  to  surrender  part  of  this  common  stock  in  connection 
with  the  sale  of  bonds,  they  can  usually  retain  a  sufficient 
amount  to  control  the  company.  If,  on  the  other  hand,  they 
are  obliged  to  sell  common  stock  to  obtain  this  $1,000,000, 
they  must  admit  each  share  of  stock  to  participation  in  their 
earnings  at  a  higher  rate  than  that  which  bonds  usually  carry. 
Furthermore,  when  the  security  is  good,  bonds  can  be  more 
readily  sold,  and  at  proportionately  higher  prices,  than  any 
kind  of  stock.  For  these  reasons,  from  the  standpoint  of  the 
banker  and  promoter,  bonds  are  preferred  whenever  the  nature 
of  the  business  admits  of  their  issue. 

We  now  take  up  the  classification  of  industries  and  en- 
terprises into  those  which  furnish  satisfactory  security  for 
the  issue  of  bonds  and  those  which  do  not.  In  the  discussion 
of  the  mortgage  as  security  for  a  bond  issue,  we  have  seen 
what  great  attention  is  paid  to  the  enumeration  of  the  items 
of  property  of  a  corporation,  how  carefully  this  property  is 
segregated  to  protect  the  holders  of  the  bonds.  When  this 
property  is  nonspecialized,  that  is  when  it  can  be  put  to  a 


62  COKPOEATION   FINANCE 

variety  of  uses,  so  that  it  can  readily  find  a  purchaser,  for 
example,  real  estate,  or  stocks  of  finished  goods,  or  materials, 
then  the  property  itself  furnishes  the  security  for  the  loan. 
When,  however,  the  property  of  the  company  is  specialized 
to  the  use  of  a  particular  business,  such  as  a  railroad  or 
manufacturing  plant,  where  the  business  must  be  carried  on 
in  a  certain  place  and  by  people  who  are  skilled  in  its  man- 
/         agement,  and  where  the  property,  once  devoted  to  a  particular 
j         use,  can  be  turned  to  no  other  use,  the  real  security  of  the 
creditor  is  not  the  property  but  the  earnings  of  the  property. 
With  a  mortgage  on  centrally  located  real  estate,  the  selling 
value  of  the  real  estate  can  be  easily  realized,  and  a  loan 
can  be  made  without  reference  to  the  profitableness  of  the 
business  which  is  to  be  carried  on  in  the  property.    One  million 
dollars,  however,  may  be  invested  in  the  property  of  a  manu- 
facturing company  which  could  not  be  sold  for  any  other 
use  than  the  one  to  which  it  is  specifically  devoted,  for  less 
than  $100,000.     The  security  of  the  creditors  is  here  the 
profitableness  of  the  business   which  is   carried  on  in  the 
\  factory. 
•    \     Furthermore,  a  business  is  not  an  aggregate  of  physical 
property  but  consists  of  physical  property — buildings,  boilers, 
machine  tools — plus  an  industrial  opportunity,  plus  the  or- 
ganization and  ability  to  operate  the  business.    The  corpora- 
tion owning  this  business  borrows  the  money,  and  the  value 
^of  the  business  is  based  upon  its  earnings.  ^  The  physical 
.  T  property,  which  is  set  aside  with  such  a  profusion  of  formal- 
^       ity  in  the  mortgage,  is  merely  the  visible  symbol  of  its  earn- 
vy     ing  capacity.     Without  the  plant,  it  is  true,  earnings  would 
^      be  impossible,  but  the  plant  has  little  value  unless  the  spirit 
'   r  of   profitable   life   is   breathed   into   it   by   an   intelligently 
managed  organization.     In  estimating  the  stability  of  differ- 
ent classes  of  enterprises  to  furnish  security  for  bond  issues, 
we  must  take  account  first  of  this  factor  of  earnings. 

Since  the  bondholder  is  solely  interested  in  the  security 
of  his  principal,  and  regular  payment  of  his  interest,  and 
since  both  security  and  interest  depend  upon  the  permanence 


/f 

/ 


THE   ISSUING   OF   SECUKITIES  63 

of  income,  other  things  being  equal  the  companies  with  the 
most  stable  earnings  or  a  market  for  their  products  at  all 
times  reasonably  satisfactory   furnish  the  best  security  for     , 
bonds.    Stability  of 'earnings  depends  upon  (1)  the  possession  / 
of  a  monopoly;  (2)  good  management;  and  (3)  the  charac-     < 
ter  of  the  business.  / 

Monopoly  is  exclusive  or  dominant  control  over  a  market. 
The  more  complete  this  control,  the  more  valuable  is  ^  the 
monopoly.  The  advantage  of  monopoly  lies  in  the  fact 
that  the  prices  of  services  or  commodities  are  controlled  by 
the  producer  rather  than  by  the  consumer.  In  the  long  run, 
the  returns  in  profits  from  monopoly  are  greater  than  when 
the  consumer  is  able  to  play  off  one  seller  against  another, 
and  so  secure  concessions  in  prices.  Monopolies  are  of  va- 
rious origins.  The  most  familiar  are  ( 1 )  franchises,  the  right 
to  use  public  property  for  private  purposes,  for  example,  the 
furnishing  of  light,  water  and  transportation,  (2)  control  of 
sources  of  raw  material  supply  such,  for  example,  as  that  which 
the  United  States  Steel  Corporation  exercises  over  the  Lake  / 
Superior  ore  deposits,  (3)  patents,  which  give  the  exclusive  / 
right  to  manufacture  an  article  for  seventeen  years;  and 
(4)  high  cost  of  duplicating  plant,  which  secures  the  rail-  i 
roads  in  thickly  settled  territory,  where  land  values  are  high,  ' 
and  where  terminal  sites  are  especially  costly,  against  com- 
petition from  the  duplication  of  their  facilities.  Of  these 
forms  of  monopoly,  those  conferred  by  franchises  and  by  high 
costs  of  duplication  are  most  valuable  from  the  standpoint 
of  bond  security.  Next  comes  possession  'of  supplies  of  raw 
material,  and  last  patent  monopoly. 

Stability  of  earnings  also  depends  upon  good  manage- 
ment. This  means  not  merely  economical  operation  but  culti- 
vation of  new  business.  Stability  of  earnings  depends  finally 
upon  the  breadth  of  the  demand.  In  manufacturing  indus- 
tries, for  example,  those  enterprises  which  produce  raw  ma- 
terials and  the  necessities  of  life  have  a  more  stable  demand 
than  those  which  produce  highly  finished  articles  and  luxuries. 

We  may  classify  enterprises  according  to  the  quality  of 


64  CORPOKATION   FINANCE 

the  security  which  they  offer  for  an  issue  of  bonds.  Mining 
enterprises — coal,  iron,  copper,  lead — furnish  a  basis  for 
bond  issues  only  when  the  extent  of  the  resource  is  known. 
When  a  bed  of  coal  or  a  deposit  of  ore  has  been  sur- 
veyed and  its  contents  estimated,  it  furnishes  a  basis  for 
a  bond  issue  up  to  a  moderate  percentage  of  its  market 
value.  Industrial  enterprises  are  mortgaged,  as  a  rule, 
only  when  possessed  of  mineral  properties  or  real  estate. 
The  limit  of  bond  issues  in  these  cases  is  narrow,  and  it  has 
a  close  relation  to  the  selling  value  of  the  property.  Public 
Service  Corporations,  operating  under  franchises  liberal  in 
terms,  furnish  excellent  security  for  bond  issues.  The  mo- 
nopoly of  street  railway  or  gas  companies,  which  may  have 
the  exclusive  right  to  serve  the  consumer  for  a  term  of  years 
at  prices  which  leave  a  large  margin  over  the  cost  of  produc- 
tion, is  so  perfect  that  the  bondholder  runs  little  risk  of 
lending  to  a  high  percentage  of  the  cost  of  the  property. 
Railroads  furnish  perhaps  the  best  basis  of  bond  issue  be- 
cause of  the  stability  of  the  demand  for  the  transportation 
service  which  is  rendered  to  every  industry,  and  because  of 
the  high  cost  of  duplicating  the  railroad  plant,  which  secures 
existing  lines  in  the  possession  of  valuable  territories,  and, 
within  the  limits  imposed  by  law,  enables  them  to  fix  their 
rates  on  freight  and  passenger  traffic.  Most  of  the  bonds 
which  are  outstanding  in  the  United  States  are  based  on 
railroad  property. 

We  now  take  up  the  amount  of  bonds  which  can  be  issued. 
The  amount  of  bonds  should  not  be  so  great  as  to  impose 
upon  the  corporation  a  burden  of  interest  charges  which  is 
above,  or  even  equal  to,  a  conservative  estimate  of  the  earning 
power  of  the  company  under  the  worst  conditions  which  it 
is  likely  to  meet.  If  a  corporation  do^s  not  pay  its  interest, 
and  is  put  into  bankruptcy,  its  affairs  are  thrown  into  con- 
fusion. Even  though  it  is  relieved  from  bankruptcy  without 
reorganization  by  an  improvement  in  its  business,  serious 
damage  will  always  be  found  to  have  resulted.  In  issuing 
boiids,  therefore,  conservative  financiers  keep  in  mind  the 


THE   ISSUING   OF   SECURITIES  65 

danger  of  bankruptcy  to  result  from  business  depression  or 
other  unforeseen  contingencies,  and  regulate  the  amount  of 
debt  to  guard  against  any  such  untoward  event. 

The  considerations  which  relate  to  the  stability  of  differ- 
ent enterprises  as  security  for  bonds  can  also  be  employed 
to  determine  the  percentage  of  income  which  can  safely  be 
represented  by  interest  on  bonds.  A  railroad  company  can 
safely  assume  interest  payments  which  bear  a  much  higher 
proportion  to  its  income  than  a  manufacturing  company 
whose  earnings  fluctuate  within  much  wider  limits.  In  most 
cases,  no  more  than  twenty  per  cent  of  the  gross  earnings 
of  a  railroad  company  should  be  represented  by  interest 
charges.  This  standard  is  established  in  one  of  the  most 
stable  of  industries.  It  furnishes  a  limit  above  which,  speak- 
ing generally,  no  company  should  go  in  pledging  its  earn- 
ings for  the  payment  of  interest  charges. 

In  fixing  the  amount  of  bonds  to  be  issued,  provision 
should  be  made  for  future  issues  of  capital.  Under  normal 
conditions,  every  corporation,  if  well  managed,  will  expand 
its  operations  and  will  largely  increase  its  initial  capital  in 
handling  the  increased  volume  of  business  which  the  growth 
of  the  country  and  the  energy  of  its  management  will  bring 
to  it.  If  the  capital  of  the  company  was  originally  obtained 
by  an  issue  of  bonds,  it  will  again  resort  to  its  credit  to  pro- 
vide funds  for  the  enlargement  of  its  plant.  The  corporate 
mortgage,  however,  is  an  obstacle  to  the  subsequent  sale  of 
the  bonds.  When  a  mortgage  authorizes  $5,000,000,  this 
indebtedness  cannot  be  increased  without  the  consent  of  the 
bondholder,  which  is  seldom  obtained.  The  corporation  is 
not  likely  to  be  in  a  position  to  offer  inducements  suffi- 
cient to  persuade  the  bondholder  to  relax  the  obligation  of 
his  mortgage,  and  permit  an  increase  in  the  amount  of 
debt  which  it  secures.  Eailing  this  provision,  the  natural 
method  for  the  company  to  adopt  in  raising  money  for  ex- 
tensions will  be  to  mortgage  these  extensions,  either  directly, 
or  by  organizing  separate  companies  to  issue  their  mortgage 
bonds.    When  the  company  is  very  strong  in  earnings,  and 


66  CORPORATION   FINANCE 

its  first  mortgage  debt  is  small,  it  may  also  raise  money  by 
a  second  or  general  mortgage. 

These  methods,  however,  while  available  and  desirable 
in  some  cases,  are  not  so  effective  as  a  first  mortgage  on  the 
entire  property  of  the  company  in  satisfying  the  demands 
of  the  investor  that  the  bonds  which  he  purchases  should  be 
properly  secured.  Take,  for  example,  the  case  of  a  railroad 
building  a  line  from  Kansas  City  to  Galveston.  Upon  this 
line  is  placed  a  first  mortgage,  securing  an  issue  of  bonds 
sufficient  to  pay  the  cost  of  construction.  The  railroad  pros- 
pers, and,  within  a  few  years,  the  necessity  arises  for  a  large 
amount  of  branch  line  mileage.  If  the  first  mortgage  does 
not  contain  the  provision,  which  is  usual  in  the  older  mort- 
gages, that  the  lien  of  the  indenture  should  include  all  prop-  x- 
erty  owned  or  thereafter  acquired,  it  would  be  possible  for 
the  company  to  issue  bonds  secured  by  a  first  mortgage  upon 
the  branches  and  a  second  mortgage  upon  the  main  line. 
These  bonds  would  be  inferior  to  the  bonds  secured  by  the 
first  mortgage  upon  the  main  line,  because  the  branches  are 
not  indispensable  to  the  main  line,  while  the  main  line  is  1 
indispensable  to  the  branches.  The  holders  of  bonds  secured 
by  a  first  mortgage  upon  branch  lines,  in  case  of  default  and 
foreclosure  proceedings,  come  into  possession  of  property 
which  depends  upon  other  property  for  its  value.  On  the 
other  hand,  foreclosure  of  a  mortgage  upon  the  main  line 
would  bring  into  the  possession  of  the  bondholders  property 
which  could  stand  upon  its  own  feet,  which  would  not  depend 
wholly  or  mainly  upon  the  branches  for  its  traffic,  and  to 
whose  earning  power  the  possession  of  branches  would  not 
be  essential. 

The  best  security  for  bonds  issued  by  such  a  corporation 
is  the  lien  of  a  first  mortgage  upon  the  entire  property  of 
a  company,  a  lien  protecting  not  merely  the  bonds  first 
issued,  but  all  later  issues,  so  that  every  bond  may  be  secured 
by  the  lien  upon  the  entire  system.  In  case  of  default, 
holders  of  bonds  secured  by  such  a  mortgage  come  into  the' 
possession  of  the  property  as  a  whole.     Their  owners  need 


THE   ISSUING    OF   SECURITIES  67 

not  make  concessions  to  the  holders  of  securities  protected 
by  first  mortgages  on  certain  parts  of  the  system.  Recent 
financial  plans,  recognizing  the  value  of  the  best  security 
in  securing  a  ready  market  and  a  high  price  for  bonds, 
authorize  amounts  of  first  mortgage  bonds  which  shall  be 
sufficient  to  provide,  not  merely  for  the  original  construction 
of  the  property,  but  for  all  additions  and  improvements.  An 
example  of  such  an  issue  is  furnished  by  the  Chicago  Bell 
Telephone  Company  which,  in  1908,  authorized  an  issue  of 
$50,000,000  of  first  mortgage  bonds  of  which  $3,000,000  were 
to  be  issued  immediately,  and  the  remainder  over  a  period 
of  years  as  required. 

At  this  point,  however,  we  meet  an  ol)jection.  One  of 
the  chief  advantages,  from  the  standpoint  of  security,  of  a 
mortgage  bond  over  any  kind  of  stock,  is  the  limitation  of 
its  issue.  The  buyer  of  a  mortgage  bond  knows  exactly  what 
his  security  is  in  relation  to  the  obligations  outstanding 
against  it.  If  $5,000,000  of  first  mortgage  bonds  are  sold 
the  investor  knows  that  this  amount  can  never  be  increased 
without  his  consent.  If,  however,  he  bought  preferred  or 
common  stock,  in  the  absence  of  special  restrictions,  there 
would  be  no  limit  to  the  increase  in  the  number  of  shares. 
It  is  necessary,  therefore,  in  providing  for  a  large  bond 
reserve  in  a  financial  plan,  to  satisfy  the  investor  that  the 
large  amount  of  bonds  held  in  reserve  to  be  issued  from  time 
to  time  as  the  company's  business  expands,  does  not  weaken! 
the  security  of  the  bonds  which  he  is  asked  to  purchase. 

The  bondholder  should  have  no  objection  to  the  unlimited 
issue  of  bonds  secured  by  the  same  mortgage  which  protects 
his  own  holdings,  provided  that  the  additional  proceeds  of 
the  additional  issues  could  be  invested  to  produce  an  income 
as  great  or  greater  than  that  earned  by  the  initial  investment. 
Indeed,  from  one  point  of  view,  the  sale  of  additional  bonds 
and  their  investment  to  yield  to  the  business  more  than  their 
interest,  strengthens  the  position  of  all  the  bonds,  especially 
if  any  large  part  of  these  excess  profits  are  left  in  the  busi- 
ness.   The  earnings  over  interest  charges  are  the  protection 


68  CORPORATION  FINANCE 

of  the  bondholder's  interest.  The  surplus  of  assets  over  bond 
liabilities  may  be  considered  as  an  insurance  reserve  against 
such  an  impairment  of  the  assets  of  the  business  as  might 
threaten  the  security  of  the  bonds.  If  a  company  is  well 
managed,  and  if  its  improvements  and  extensions  are  conser- 
vatively made,  .the  bondholder  should  have  no  objection  to 
an  increase  of  the  amount  of  the  debt  secured  by  the  same 
mortgage  which  protects  his  own  bonds.  It  is,  however,  dif- 
ficult to  give  him  such  assurances,  and  to  satisfy  him  that, 
without  specific  safeguards  in  the  mortgage,  his  earnings  will 
not  be  jeopardized  by  additional  issues.  A  bond  reserve  is, 
therefore,  usually  included  in  the  financial  plan  with  such 
stipulations  that  the  investor  knows  in  advance  the  condi- 
tions under  which  the  various  installments  of  bonds  author- 
ized can  be  sold. 

A  company,  arranging  for  a  large  bond  reserve,  must 
provide  safeguards  in  the  mortgage  which  will  assure  the 
investor  that  the  proceeds  of  the  issues  of  bonds  which  may 
follow  those  which  he  buys  will  be  so  invested  as  to  strengthen 
his  security.  The  first  of  these  safeguards  is  a  limitation 
on  the  amount  of  bonds  to  be  issued  in  any  one  year.  A 
company  with  $50,000,000  of  bonds  authoi^ized,  which  pro- 
poses to  issue  $20,000,000  or  $30,000,000  within  a  short  time 
after  the  first  issue  of  $5,000,000,  might  weaken  the  con- 
fidence of  the  investor  in  the  security  of  his  bonds.  The 
investor  could  not  be  made  to  understand  why  such  a  large 
investment  would  be  necessary.  He  is  assured  on  this  point 
by  such  a  restriction  on  the  amount  to  be  annually  issued  as 
appears  in  the  mortgage  of  the  Bell  Telephone  Company 
already  referred  to,  which  provides  that  no  bonds  in  addition 
to  the  $5,000,000  sold  on  that  date,  could  be  issued  until 
after  December  1,  1909,  and,  thereafter,  the  trustee  is  per- 
mitted to  certify  bonds  not  exceeding  $5,000,000  per  annum. 

We  have  already  seen  that,  if  the  same  earnings  are  ob- 
tained on  the  investment  of  the  proceeds  of  successive  bond 
issues,  as  were  shown  on  the  first  expenditure,  the  position 
of  the  bondholder  would  not  be  weakened.    There  is,  how- 


THE   ISSUING    OF   SECUKITIES  69 

ever,  always  danger  that  this  rate  of  earnings  may  not  be 
realized.  In  order  to  insure  the  bondholder  that  there  will 
always  be  a  wide  margin  of  safety  in  the  cost  of  any  property 
acquired  with  the  proceeds  of  subsequent  issues  of  bonds, 
provision  is  made,  again  quoting  from  the  restrictions  in 
the  mortgage  of  the  Chicago  (Bell)  Telephone  Company, 
that  the  "total  amount  of  bonds  issued  sliall  at  no  time 
exceed  fifty  per  cent  of  the  value  of  the  property  as  repre- 
sented by  its  total  assets,  nor  more  than  sixty  per  cent  of 
the  real  estate  and  construction  account."  This  protects  the 
bondholders  against  an  overestimate  by  the  directors  of  the 
earnings  from  the  new  property  by  providing  an  ample  mar- 
gin in  the  value  of  the  property  of  the  company  above  the 
mortgage  obligations. 

Such  restrictions,  however,  are  unusual.  As  a  rule,  the 
bondholder  will  be  satisfied  if  a  limitation  is  made  similar 
to  the  following  in  the  mortgage  securing  the  bonds  of  the 
Pacific  Telephone  &  Telegraph  Company :  "  Of  the  first  mort- 
gage and  collateral  trust  bonds  authorized,  $12,000,000  may 
be  issued  for  extensions,  additions,  etc.,  but  only  up  to  66| 
per  cent  of  the  cost  thereof."  The  Pacific  Telephone  &  Tele- 
graph Company  is  more  liberal.  The  trust  deed  of  this 
company  provides  that  "  of  the  remaining  $25,000,000  bonds 
over  the  $3,000,000  first  issued,  $22,000,000  shall  be  issuable 
only  to  cover  actual  expenses  on  plant  and  improvements, 
but  at  no  time  shall  the  amount  of  bonds  issued  exceed  an 
amount  equal  to  eighty-five  per  cent  of  such  expenditures, 
nor  shall  they  be  issued  to  provide  for  repairs." 

Another  form  of  restriction  makes  additional  bond  issues 
depend  upon  earnings.  A  common  provision  is  that  inserted 
in  the  mortgage  of  the  Utica  &  Mohawk  Valley  Railroad 
Company  where  the  bonds  reserved  "  could  be  issued  for  sev- 
enty-five per  cent  of  the  actual  cash  cost  of  additions  and 
improvements,  but  not  until  the  net  earnings  for  the  preced- 
ing twelve  months  are  equal  to  or  exceed  double  the  interest 
charge  on  the  total  amount  of  bonds  outstanding,  including 
those  to  be  issued."    It  is  better,  from  the  standpoint  of  the 


70  COKPORATION   FINANCE 

holder,  to  limit  the  issue  of  new  bonds  with  reference  to 
the  amount  of  surplus  earnings  of  the  company  than  by 
any  other  standard,  although  the  provision  that  bonds  can 
be  issued  only  up  to  a  reasonable  percentage  of  the  cash  cost 
of  improvements  is  also  desirable. 

A  common  stipulation  for  the  protection  of  the  bond- 
holder, whether  bonds  are  reserved  or  not,  with  a  company 
whose  business  is  subject  to  wide  fluctuations,  provides  that  a 
certain  surplus  of  quick  assets  over  liabilities  should  be  main- 
tained at  all  times.  A  large  amount  of  convertible  assets  in 
proportion  to  its  liabilities  insures  a  company  against  financial 
embarrassment.  It  was  a  lack  of  quick  assets  that  carried 
down  the  Westinghouse  Electric  and  Manufacturing  Com- 
pany in  1907.  In  the  mortgage  securing  the  $10,000,000  of 
five  per  cent  gold  bonds  issued  by  the  Republic  Iron  &  Steel 
Company  the  following  provision  appears : 

The  net  cash  and  quick  assets  over  and  above  lia- 
bilities, other  than  the  $10,000,000  of  bonds  and  the 
interest  thereon,  shall  never  be  less  than  $6,500,000 
while  any  of  the  said  issue  of  bonds  remains  out- 
standing, until  the  total  amount  of  such  issue  of 
$10,000,000  not  canceled,  shall  be  less  than  $6,500,000, 
and  thereafter  shall  never  be  less  than  the  amount  of 
such  $10,000,000  of  bonds  at  any  time  uncanceled. 
By  the  phrase  "  cash  and  quick  assets  "  is  meant  cash 
in  bank,  good  accounts  and  bills  and  notes  receivable, 
contract  notes,  or  similar  or  other  securities  received 
on  the  sale  of  products  of  the  Republic  Company, 
raw  material,  manufactured  products  (it  being  un- 
derstood that  the  material  shall  be  figured  at  actual 
cost  without  interest  if  cost  is  below  the  market 
value  thereof  at  the  time  of  the  valuation  thereof 
hereunder,  but  at  market  value  if  at  such  time  below 
cost  thereof).  It  is  expressly  understood  and  agreed 
that  in  the  term  raw  material  no  ore  or  coal  shall 
be  included  except  such  as  has  actually  been  mined 
and  is  then  on  the  surface  at  the  mines  available  for 
shipment  by  rail  or  in  transit  or  at  upper  or  lower 
lake  docks,  or  at  works. 


THE   ISSUING   OF   SECUKITIES  71 

This  requirement  resulted,  in  1907,  in  the  suspension  by 
the  Kepublic  Iron  &  Steel  Company  of  dividends  on  its  pre- 
ferred stock,  all  the  cash  assets  of  the  company  being  neces- 
sary to  preserve  the  stipulated  margin  of  quick  assets  above 
liabilities. 

We  may  summarize  the  restrictions  upon  the  issue  of 
bonds  reserved  to  be  sold  under  first  mortgage  as  follows: 

(1)  A  limitation  on  the  amount  which  can  be  sold  in 
any  one  year; 

(2)  Each  installment  to  be  restricted  to  a  certain  per- 
centage of  the  cost  of  additions  or  improvements  upon  which 
the  proceeds  of  the  bonds  are  expended,  the  percentage  vary- 
ing with  the  type  of  property  and  the  permanence  of  the 
business. 

(3)  That  the  earnings  of  the  company  shall  show  a  sub- 
stantial margin  over  its  interest  or  fixed  charges,  including 
the  interest  charges  on  the  new  bonds; 

(4)  In  special  cases,  a  provision  that  a  surplus  of  quick 
assets  shall  always  be  maintained  for  the  protection  of  the 
bondholder. 

If  these  restrictions  are  included  in  the  mortgage,  the 
existence  of  a  large  bond  reserve  need  cause  no^apprehension 
to  the  holders  of  bonds  already  issued  under  the  same  mort- 
gage. The  company,  for  its  part,  is  enabled  to  raise  money 
on  the  most  favorable  terms  and  each  succeeding  capital 
expenditure,  on  account  of  the  margin  required  in  the  cost 
of  the  property,  increases  the  security  of  the  bonds  already 
outstanding. 


CHAPTER   VI 

STATE  SUPERVISION  OF  SECURITY  ISSUES 

Another  form  of  protection,  available  for  the  investor 
against  the  excessive  or  improper  issue  of  bonds  by  corpora- 
tions, is  furnished  by  the  State.  In  some  States,  the  amount 
of  debt  which  can  be  incurred  by  a  company  is  limited  by 
statute.  This  is,  however,  unusual.  The  stockholders  are 
dealing  with  their  own  property.  The  creditor  is  supposed 
to  be  able  to  look  after  his  own  interests.  Arbitrary  restric- 
tions on  indebtedness  are,  furthermore,  objectionable  in  that 
they  may  interfere  with  the  development  of  a  company's 
business.  A  better  safeguard  to  the  stockholder  and  investor 
against  unwise  issue  of  securities  is  furnished  by  the  Public 
Service  Commission.  These  commissions  are  found  in  almost 
every  State.  In  only  a  few  of  the  larger  States,  however, 
have  the  commissions  been  clothed  with  sufficient  powers  to 
make  their  work  really  effective.  In  Massachusetts,  New 
York,  Maryland,  Wisconsin,  and  Kansas  the  powers  of  the 
Public  Service  Commission  are  sweeping.  The  New  York 
Commissions,  for  example,  are  given  supreme  control  over 
all  kinds  of  public  service  corporations,  including  railroads, 
street  railroads,  lighting  and  gas  and  telephone  and  tele- 
graph companies.  The  supervisory  and  regulative  powers 
of  the  commissions  extend  to  character  of  service,  to  rates 
and  fares,  and  to  the  approval  of  the  issue  of  stocks,  bonds 
and  other  forms  of  indebtedness.  In  this  last  power,  the 
investor  finds  a  considerable  safeguard  against  the  improper 
issue  of  securities. 
72 


STATE   SUPERVISION   OF   SECURITY  ISSUES    73 

The  nature  of  this  power  over  security  issues  is  indicated 
by  the  following  extract  from  Section  55  of  the  Act  Creat- 
ing the  Public  Service  Commissions  of  New  York : 

Any  common  carrier,  railroad  corporation  or  street 
railroad  corporation  organized  under  the  laws  of  the 
State  of  New  York,  may  issue  stocks,  bonds,  notes 
or  other  evidences  of  indebtedness  payable  at  periods 
of  more  than  twelve  months  after  the  date  thereof, 
when  necessary  for  the  acquisition  of  property,  the 
construction,  completion,  extension  or  improvement  of 
its  facilities,  or  for  the  improvement  or  maintenance 
of  its  service  or  for  the  discharge  or  lawful  refunding 
of  its  obligations,  provided  and  not  otherwise  that  there 
shall  have  been  secured  from  the  proper  commission 
an  order  authorizing  such  issue,  and  the  amount 
thereof  and  stating  that,  in  the  opinion  of  the  com- 
mission, the  use  of  the  capital  to  be  secured  by  the 
issue  of  such  stock,  bonds,  notes,  or  other  evidences 
of  indebtedness  is  reasonably  required  for  the  said  pur- 
pose of  the  corporation.  For  the  purpose  of  enabling 
it  to  determine  whether  it  should  issue  such  an  order, 
the  commission  shall  make  such  inquiry  or  investi- 
gation, hold  such  hearings  and  examine  such  wit- 
nesses, books,  papers,  documents  or  contracts  as  it 
may  deem  of  importance  in  enabling  it  to  reach  a 
determination. 

Under  this  power,  every  corporation  proposing  to  issue 
or  authorize  new  securities  must  apply  to  the  Public  Service 
Commission  for  authority,  and  the  authority  will  not  be 
given  until  a  thorough  investigation  has  been  made  into 
the  security  back  of  the  bonds  and  the  purposes  for  which 
the  money  is  to  be  spent. 

The  primary  purpose  of  giving  the  commissions  power 
over  issues  of  securities  was  to  protect  the  public  against  ex- 
cessive issues  of  capital  by  public  service  corporations  on  the 
ground  that  an  excessive  capitalization  might  be  used  to 
defend  rates  or  prices  which  were  excessive.  In  the  exercise 
of  this  power,  however,  the  commissions  have  gone  much  far- 


74  COKPOEATION   TINANCE 

ther  and  have  undertaken  the  task  of  protecting  the  investor 
against  unwise  capital  expenditures.  The  Commission  of  the 
Second  District  of  New  York  has  outlined  its  method  of 
procedure  in  cases  involving  the  authorization  of  bond  issues 
as  follows :  ^ 

"  In  passing  upon  the  application  for  leave  to  issue  addi- 
tional capital  stock,  the  Commission  will  consider: 

"  Whether  there  is  reasonable  prospect  of  fair  return  upon 
the  investment  proposed,  to  the  end  that  securities  having 
apparent  worth  but  actually  little  or  no  value  may  not  be 
issued  with  our  sanction. 

"  We  think  that  to  a  reasonable  extent  the  interests  of  the 
investing  public  should  be  considered  by  us  in  passing  upon 
these  applications. 

"  The  Commission  should  satisfy  itself  that,  in  a  general 
way,  the  venture  will  be  likely  to  prove  commercially  feas- 
ible, but  it  should  not  undertake  to  reach  and  announce  a 
definite  conclusion  that  the  new  construction  or  improvement 
actually  constitutes  a  safe  or  attractive  basis  for  investment. 
Commercial  enterprises  depend  for  their  success  upon  so 
many  conditions  which  cannot  be  foreseen  or  reckoned  with 
in  advance,  that  the  duty  of  the  Commission  is  discharged 
as  to  applications  of  this  character  when  it  has  satisfied 
itself  that  the  contemplated  purpose  is  a  fair  business  prop- 
osition." 

In  practice,  however,  the  commission  has  made  such  care- 
ful investigation  as  to  warrant  the  inference  which  has  been 
generally  drawn  by  the  investing  public  that  for  them  to 
authorize  a  bond  issue  is  equal  to  their  guarantee  that  the 
issue  is  good.  In  the  case  of  the  Eochester,  Corning,  and  El- 
mi  ra  Traction  Company  decided  March  31,  1908,  the  commis- 
sion outlined  in  detail  the  methods  of  investigation  which  it 
proposed  to  follow  in  determining  the  amount  of  bonds  which 
could  be  safely  issued  by  a  newly  organized  enterprise  as 
follows:  , 

1  "Second  Annual  Report  of  the  Public  Service  Commission,"  p.  12. 


STATE   SUPERVISION    OF   SECURITY   ISSUES    75 

An  estimate  will  be  made  from  a  consideration  of 
the  results  of  operation  of  existing  roads  of  the  prob- 
able gross  earnings. 

An  estimate  will  be  made  in  like  manner  of  the 
probable  operating  expenses,  taxes,  and  depreciation 
charges. 

The  excess  of  earnings  over  the  disbursements  which 
must  be  made  before  fixed  charges  can  be  met  rep- 
resents the  sum  which  is  applicable  to  fixed  charges. 

The  maximum  bond  issue  which  will  be  allowed 
must  be  determined  by  the  sum  thus  ascertained  to 
be  applicable  to  the  payment  of  the  interest  charge. 

No  bond  issue  should  be  permitted  creating  an  in- 
terest charge  beyond  an  amount  which  it  is  reason- 
ably certain  can  be  met  from  the  net  earnings. 

Stock  representing  a  cash  investment  should  be  re- 
quired to  an  amount  sufficient  to  afford  a  moral  guar- 
antee that  in  the  judgment  of  those  investing  the 
enterprise  is  likely  to  prove  commercially  successful. 

The  order  authorizing  such  stock  and  bond  issues 
will  contain  approximate  provisions  designed  to  secure 
the  construction  of  the  road  in  accordance  with  the 
plans  and  specifications  upon  which  the  authorization 
was  made  and  not  in  excess  of  the  actual  require- 
ments. 

If  the  allowance  proves  inadequate  for  the  required 
purposes,  an  application  for  further  capitalization  may 
be  made,  upon  which  application  the  expenditure  of 
the  proceeds  of  stock  and  bonds  already  authorized 
must  be  shown  in  detail. 

After  an  issue  of  bonds  has  passed  this  searching  scrutiny, 
the  investor  need  have  little  fear  concerning  the  safety  of  his 
bonds,  whether  a  bond  reserve  many  times  the  amount  of 
the  initial  issue  has  been  created  or  not.  Indeed,  in  one 
notable  instance,  the  first  mortgage  bonds  of  the  Chicago 
Railways  Company,  which  are  issued  under  restrictions  sim- 
ilar to  those  which  have  been  outlined,  such  confidence  has 
been  placed  in  the  efficacy  of  the  precautions  taken  to  guard 
against  overissue,  that  bonds  may  be  issued  without  limit 
under  a  so-called  "  open-end  mortgage,"  every  bond,  no  mat- 


76  CORPOKATION   FINANCE 

ter  to  what  amount  these  may  be  issued,  being  equally  secured 
as  every  other  bond,  by  a  first  lien  upon  the  property  of 
the  company.  There  is  no  essential  difference  between  a 
large  bond  reserve  and  an  open-end  mortgage.  The  open- 
end  mortgage,  however,  on  account  of  the  uncertainty  as  to 
the  amount  of  bonds  which  may,  at  some  time  in  the  future, 
be  issued,  is  inferior,  in  the  opinion  of  most  investors,  to  a 
large  bond  reserve.  It  is,  moreover,  in  practice,  no  more 
effective  in  providing  for  the  future  capital  needs  of  the 
corporation. 

When  a  Public  Service  Commission  has  authorized  the 
issue  of  securities,  it  is  by  implication  bound  to  protect  the 
company  whose  application  it  has  authorized,  not  merely 
against  the  ill-advised  action  of  their  directors  in  using  the 
credit  of  the  company  for  improper  purposes,  but  also  against 
competing  enterprises  for  which  there  is  no  public  necessity 
and  which  would  not,  therefore,  prove  profitable.  The  New 
York  Public  Service  Commission  for  the  Second  District, 
for  example,  in  1908,  refused  the  application  of  the  Buffalo, 
Eochester  &  Eastern  Eailroad  Company  for  authority  to 
issue  securities  for  the  construction  of  a  line  of  railroad  from 
Buffalo  to  Albany,  paralleling  the  line  of  the  New  York  Cen- 
tral, on  the  ground  that  the  new  enterprise  would  not  prove 
profitable,  and  that  the  New  York  Central  would  be  injured 
without  any  public  benefit  resulting.  The  new  line  proposed 
to  interchange  traffic  at  Albany  with  lines  traversing  New 
England,  but  the  commission  pointed  out  that  the  New 
England  lines  were  not  able  to  handle  the  traffic  already 
delivered  to  them  at  Albany.  This  was  sufficient  reason  for 
refusing  to  authorize  the  construction  of  another  line  which 
would  make  the  congestion  at  the  Hudson  River  even  more 
acute. 

At  the  time  the  New  York  Public  Service  Commissions 
were  instituted,  serious  apprehensions  were  expressed  by 
financial  interests  lest  the  new  laws,  because  they  took  away 
from  the  directors  or  stockholders  of  corporations  so  much  of 
the   control  which  they  had  previously   exercised  over  the 


I 


STATE   SUPEKVISION   OF   SECURITY  ISSUES     77 

issues  of  new  capital,  would  seriously  interfere  with  the 
eiforts  of  companies  to  provide  funds  for  development. 
Indeed,  the  passage  of  the  New  York  law  produced  a 
feeling  of  consternation  among  bankers  and  investors.  As 
the  commissions  have  progressed  with  their  work,  how- 
ever, they  have  been  forced  into  the  position  of  virtually 
guaranteeing  every  security  whose  issue  they  approve.  So 
well  organized  and  so  favorably  regarded  are  the  Public  Ser- 
vice Commissions  by  the  investor,  as  a  result  of  the  interpre- 
tation which  they  have  placed  upon  their  powers,  that  the 
bond  salesman  offering  a  security  whose  issue  they  have  ap- 
proved has  his  work  of  persuasion  largely  accomplished.  In 
one  case  the  issue  of  bonds  by  a  Massachusetts  company 
secured  by  the  stocks  of  two  other  companies,  and  with  its 
own  stock  owned  by  a  fourth,  presenting  a  situation  almost 
incomprehensible,  were  readily  sold,  in  the  main  for  no  other 
reason  than  that  they  were  issued  under  the  authority  of  the 
Massachusetts  Commission.  Bond  dealers  and  large  inves- 
tors, with  few  exceptions,  cordially  indorse  the  control  of 
security  issues  by  public  service  commissions,  because  of  the 
assurance  which  this  control  gives  to  the  investor  that  his 
interest  will  be  safeguarded. 

We  next  inquire  concerning  the  term  of  the  bonds.  A 
new  company  has  usually  to  sell  its  bonds  at  lower  prices 
than  when  it  has  become  established.  After  the  business  has 
been  established,  the  bonds  of  the  company  can  be  sold  at 
higher  prices  or  can  be  refunded  at  lower  rates.  Although, 
therefore,  the  investor  usually  prefers  a  long  term  bond  of 
an  established  company,  a  new  company  usually  issues  a 
short-term  bond,  not  exceeding  twenty  or  thirty  years,  ex- 
pecting that  when  it  matures,  instead  of  selling  on  a  five  or 
five  and  a  half  per  cent  basis,  its  bonds  will  sell  to  yield 
four  or  four  and  a  half  per  cent.  It  can  then  sell  a  new 
issue  at  a  higher  price  and  retire  the  bonds  originally  issued. 
In  order  to  provide  for  refunding  the  bonds  at  lower  rates 
of  interest,  should  the  opportunity  offer,  provision  is  fre- 
quently made  in  recent  mortgages  for  retiring  the   entire 


78  COEPOKATION   FINANCE 

issue  at  a  premium  often  of  five  per  cent,  a  premium  low 
enough  not  to  prove  burdensome  to  a  company  wishing  to 
pay  off  a  six-per-cent  loan  by  making  another  loan  at  five  per 
cent,  and  yet  a  premium  which  amply  compensates  the  holder 
of  the  six-per-cent  bonds  for  any  inconvenience  he  may  suffer 
because  he  is  forced  to  change  his  investment. 

Our  next  question  concerns  the  rate  of  interest  to  be  fixed 
on  the  bonds.  Corporations  engaged  in  different  enterprises 
pay  different  rates  of  interest,  depending  upon  what  in- 
vestors in  that  particular  class  of  bonds  are  accustomed  to 
receive.  The  rate  of  interest  also  varies,  to  some  extent, 
with  the  location  of  the  enterprise.  Certain  conventional 
rates  of  interest  may  be  indicated,  varying  with  the  class  of 
enterprise  in  which  the  corporation  is  engaged.  Eailroad 
companies  can  usually  borrow  on  first  mortgage  security  at 
four  to  four  and  one  half  per  cent.  Public  service  corpora- 
tions pay  four  and  a  half  to  five  per  cent;  bonds  of  manu- 
facturing, mining,  lumber  companies,  etc.,  six  per  cent.^ 
The  explanation  of  these  differences  we  find  in  the  varying 
demand  for  different  classes  of  bonds.  The  investor  prefers 
railroad  bonds  since,  as  a  class,  these  give  him  the  best 
security.  When  corporations  engaged  in  enterprises  which, 
from  the  standpoint  of  stability  and  security  are,  in  the  minds 
of  the  investor,  inferior  to  the  railway  industry,  apply  for 
funds,  the  demand  for  their  bonds  is  weaker  than  the  demand 
for  railroad  bonds,  and  a  higher  rate  of  interest  must  be  paid. 

A  new  enterprise  must,  as  a  rule,  either  sell  its  bonds  at 
a  discount  or  give  a  bonus  in  stock.  Take,  for  example,  an 
industrial  corporation  which  has  excellent  prospects,  and  to 
which  the  creditor  is  willing  to  lend  money.  The  company 
wishes  to  borrow  at  six  per  cent,  and  approaches  a  repre- 
sentative of  the  investor  for  a  loan.  The  answer  is  that 
money  can  be  loaned  on  security  of  this  class  to  established 
companies  with  a  record  of  earnings,  interest  payments,  and 

1  Many  exceptions  can  be  found  to  these  percentages.  They  indi- 
cate, however,  the  approximate  differences  in  interest  rates  on  bonds 
issued  by  different  classes  of  enterprises. 


STATE   SUPERVISION   OF   SECURITY   ISSUES     79 

dividends,  and  that  if  the  new  company  wishes  funds  it 
must  offer  suitable  inducements.  These  inducements  can 
take  various  forms.  A  higher  interest  rate  might  be  sug- 
gested, but  this  would  create  an  unfavorable  impression  as 
to  the  security  which  the  company  offered. 

Another  method  is  to  offer  the  bonds  at  a  discount,  which 
is  equivalent  to  placing  a  higher  rate  of  interest  upon  them. 
A  six-per-cent  bond,  for  example,  which  might  be  sold  at 
par  by  an  established  company,  might  be  offered  by  a  new 
company  at  80.  This  is  equivalent  to  paying  a  higher  rate 
of  interest  than  six  per  cent.  The  corporation  sells  to  the 
investor  for  $800  the  right  to  receive  six  per  cent  on  $1,000, 
and  the  further  right,  at  the  end  of  thirty  years,  to  be 
repaid  $1,000.  In  selling  bonds  at  a  discount  a  corporation 
is  not  merely  paying  six  per  cent  for  the  money  which  it 
-receives,  but  is  also  obligating  itself  to  pay  back  a  larger 
amount  than  it  received.  The  sale  of  bonds  at  a  discount 
is,  therefore,  less  advantageous  from  the  standpoint  of  the 
company  than  to  offer  the  investor  a  higher  rate  of  interest, 
although  in  practice  it  is  more  often  resorted  to. 

To  illustrate,  leaving  out  of  consideration  the  question 
of  compound  interest,  suppose  a  corporation  has  the  alter- 
native of  selling  its  bonds  bearing  eight  per  cent  interest  at 
par  or  selling  a  six  per  cent  at  80.  The  bond  in  each  case 
is  to  be  repaid  at  the  end  of  twenty  years.  In  the  first  case 
the  corporation  receives  $1,000  down,  makes  twenty  pay- 
ments of  $80  each  and  repays  $1,000  to  the  creditor.  The 
interest  cost  is  therefore  $1,600,  or  $1.60  in  interest  for  every 
dollar  received  for  the  bond.  If,  however,  the  corporation 
sells  the  six-per-cent  bond  at  80,  it  receives  $800  in  return 
for  a  promise  to  pay  back  $1,000  at  the  end  of  twenty  years, 
and  the  obligation  to  pay  $60  a  year  during  that  time.  The 
$800  will  cost  the  corporation  $1,200  in  interest,  and  $200 
at  the  end  of  the  period,  being  the  difference  between  the 
amount  of  money  received  for  this  bond  and  the  amount 
which  must  be  paid  back  for  its  redemption,  a  total  of 
$1,400.    If  this  plan  is  adopted,  for  each  dollar  the  corpora- 


80  COEPOKATION   FINANCE 


tion  receives,  it  will  pay  in  interest  on  the  bond  $1.75,  fiftee: 
cents  per  dollar  more  than  if  the  eight-per-cent  interest  h 
been  paid. 

It  is  unusual,  however,  to  find  corporations  paying  more 
than  the  conventional  rates  of  interest.  The  sale  of  bonds 
at  a  discount  is  more  common.  The  reason  is  that  investors 
grow  suspicious  when  unusual  rates  of  interest  are  offered, 
while  they  will  very  gladly  buy  bonds  at  a  discount  which 
represent,  on  their  face,  a  moderate  rate  to  the  corporation. 

Another  method,  less  frequently  employed  than  before  the 
days  of  careful  regulation  of  capital  issues,  in  selling  the 
bonds  of  a  new  company,  is  to  make  the  creditor,  in  a  sense, 
a  partner  in  the  concern,  by  giving  him  with  his  bond  one 
or  more  shares  of  stock,  and  selling  him  the  bond  at  or  near 
par.  In  this  way,  the  corporation  receives  a  larger  amount 
of  money,  and  the  creditor  is  admitted  to  share  in  the  profits 
of  the  concern,  a  fact  which  may  reconcile  him  to  advancing 
money  to  new  enterprises  at  no  greater  rates  of  interest  than 
he  could  obtain  from  established  corporations.  The  esti- 
mates of  the  earning  power  of  the  new  company  are  usually 
so  liberal  as  to  permit  a  sufficiently  large  issue  of  stock  to 
pay  the  bonus  on  bond  sales,  and  still  leave  an  ample  supply 
in  the  hands  of  the  projectors  of  the  enterprise.  As  we  shall 
see,  however,  in  a  later  chapter,  stock  so  issued  does  not  often 
represent  much  value  to  the  ultimate  owner,  to  whom  the 
purchaser  of  the  bonds  usually  makes  haste  to  sell  his  stock 
bonus. 


I 


CHAPTER   VII 
PROVISION  FOR  THE  REPAYMENT  OF  BONDS 

The  corporation  bond  is  a  promissory  note.  It  differs 
from  a  bank  loan  only  in  the  fact  that  it  matures  in  twenty, 
fifty,  or  one  hundred  years,  instead  of  in  three  months. 
When  a  promissory  note  matures,  it  must  be  paid,  either  in 
money  or  by  a  new  note.  With  short-time  obligations,  such 
as  are  given  in  exchange  for  bank  loans,  payment  of  a  sub- 
stantial part  if  not  all  the  debt  is  expected.  With  corpo- 
ration bonds,  however,  the  custom  is  to  continue  the  debt 
indefinitely,  exchanging  new  bonds  for  maturing  bonds,  keep- 
ing the  security  intact,  and  if  possible  improving  it.  If  any 
holder  of  a  bond  at  its  maturity  wishes  cash  for  his  obli- 
gation, the  money  is  obtained  by  selling  new  bonds  to  other 
investors. 

The  reasons  for  this  practice  of  refunding  instead  of  pay- 
ing corporate  debts,  lie  in  the  relation  of  the  bondholder  to 
the  corporation.  Bonds  are  sold  to  investors  who  wish  to 
secure  a  return  on  their  money,  with  the  guarantee  that  the 
principal  sum  will  also  be  secured.  These  investments  are 
regarded  as  permanent.  The  investor  does  not  often  desire 
the  return  of  his  money.  He  wishes  the  continuance  of 
interest  payments.  If  the  principal  of  his  bond  is  paid  at 
maturity,  he  is  obliged  to  look  about  for  some  other  equally 
satisfactory  investment,  and  this,  at  the  time,  it  may  be 
hard  to  find.  The  investor  may  wish  to  convert  his  bonds 
into  cash  at  any  time.  As  long  as  the  interest  is  paid  and 
the  security  is  maintained,  he  can  easily  find  a  market  for 

81 

/ 


82,  COKPOKATION   FINANCE 

his  bond,  usually  at  a  price  equal  to  or  greater  than  the 
price  he  paid,  with  some  other  investor  who  is  looking  for  aj 
secured  income.  So,  when  its  bonds  mature,  it  is  not  difficult] 
for  the  corporation  to  offer  a  new  issue  to  take  the  place  of] 
maturing  bonds,  and  secured  by  a  first  lien  upon  the  samej 
property.  Those  of  the  old  holders  who  desire  to  continue} 
the  investment  may  take  the  new  bonds,  while  the  means] 
of  redeeming  those  bonds  whose  holders  want  their  money] 
can  be  obtained  by  selling  the  equivalent  in  the  new  bondsj 
to  new  investors.  While  the  conditions  of  security  are  met, 
the  bondholder  is  indifferent  to  the  repayment  of  his  prin- 
cipal.    At  maturity,   or  before  maturity  if  he  desires,  he 

-  can  obtain  his  money.  The  bond  investor  is  one  who  con- 
tributes capital  to  a  company  in  return  for  a  fixed  and  secured 
amount  of  its  earnings.  All  that  he  asks  of  the  corporation 
is  that  this  income  and  the  security  of  his  principal  shall  not 
be  jeopardized. 

The  repayment  of  bonds  at  maturity  is  also  opposed  to 

^  the  interest  of  the  corporation.  The  method  by  which  pro- 
vision for  repayment  can  be  made  is  to  accumulate  a  fund 
against  the  date  of  maturity  of  the  bonds.  This  fund  must  be 
in  cash  or  securities.  In  either  form  the  return  to  the  corpora- 
tion which  has  deposited  money  in  the  bank,  or  has  purchased 
bonds  to  make  provision  for  the  repayment  of  its  debt,  is  less 
than  the  company  could  earn  on  the  saiire  amount  by  investing 
it  in  its  business.  The  argument  against  accumulating  a  fund 
for  the  repayment  of  debt  is  similar  to  the  argument  for  in- 
curring the  debt  in  the  first  place.     If  a  company  can  make 

1/  ten  per  cent  on  its  investment  it  can  safely  sell  bonds  bear- 
ing five  per  cent  interest.  If,  therefore,  it  is  wise  to  incur 
an  obligation  to  pay  $1,000  in  interest  on  a  twenty-year 
bond,  and  also  to  agree  to  repay  the  principal  at  maturity 
in  return  for  $1,000  in  cash  paid  to  the  corporation,  because 
ten  per  cent  can  be  earned  on  the  $1,000,  it  is  wise  to  invest 
$50  per  year  in  the  business  of  the  company  on  which  a 
return  of  ten  per  cent  can  be  made,  rather  than  to  put  this 
$50  in  the  bank  or  in  securities  yielding  not  more  than  five 


THE   KEPAYMENT   OF   BONDS  83 

per  cent,  in  order  to  accumulate  $1,000  to  take  up  the 
twenty-year  bonds  at  maturity.  If  the  corporation  has 
money  which  it  can  set  aside  for  the  purpose  of  redeeming 
its  debt,  it  should  let  the  debt  run  and  invest  this  money  in 
extending  its  business.  .By  taking  the  second  course,  it  in- 
creases the  value  of  its  property  and  the  security  of  its  bonds, 
and  when  its  bonds  mature,  it  will  have  small  difficulty  in 
issuing  a  new  set  of  bonds,  either  to  exchange  for  the  ma- 
turing bonds,  or  to  sell  for  the  amount  necessary  to  redeem 
them. 

While  the  building  up  of  sinking  funds  is  usually  unwise, 
there  are  exceptions  to  the  rule.  The  first  class  of  com- 
panies which  should  maintain  sinking  funds  are  those  whose 
bonds  are  secured  by  a  mortgage  on  property  which  is  ex- 
hausted by  the  operations  of  the  business.  A  railroad  prop- 
erty may  be  expected  to  last  forever.  It  is  true  that  repairs 
and  replacements  are  always  going  on,  paid  for  out  of 
earnings,  and  charged  to  operating  expenses  or  depreciation. 
The  property  is,  however,  preserved  by  these  outlays.  At  the 
end  of  the  term  of  the  bonds,  their  security  is  generally  much 
larger,  as  a  result  of  the  expenditures  upon  its  replacement 
and  repair.  When,  however,  bonds  are  secured  by  a  mort- 
gage on  seams  of  coal  or  on  standing  timber,  or  on  land 
which  is  to  be  broken  up  into  small  tracts  and  sold,  the 
security  of  the  bonds  is  exhausted  by  the  operations  of  th6 
business.  Every  ton  of  coal  mined  and  sold,  every  thousand 
feet  of  timber  cut  down  and  sent  to  market,  lessens  by  just 
so  much  the  security  of  the  bonds  which  have  been  issued 
on  this  property.  When  bonds  are  issued  by  companies  oper- 
^'ting  in  such  industries,  special  provision  must  be  made  out 
of  earnings  for  paying  the  bonds,  either  by  installments  or 
when  they  mature.  The  company  must  preserve  the  relation 
between  its  debt  and  the  security  for  that  debt,  either  by 
reducing  the  amount  of  the  debt,  as  the  value  of  the  security 
falls,  or  by  replacing  the  coal  or  lumber  sold,  by  other  prop- 
erty purchased  out  of  its  income. 

The  nature  of  sinking  funds  against  bonds  secured  by 


84  COKPORATION   FINANCE 

so-called  "  wasting  "  assets  is  seen  in  the  following  statement 
of  the  safeguards  of  bonds  offered  by  a  lumber  company : 

The  mortgage  requires  the  deposit  with  the  trustee 
of  $5  per  1,000  feet,  mill  run,  on  all  timber  cut.  It 
also  requires  the  company  to  cut  and  manufacture 
exclusively  from  15,920  acres  containing  146,000,000 
feet  of  timber,  holding  the  remaining  38,000  acres, 
containing  232,000,000  feet,  as  a  reserve,  which  can- 
not be  cut  during  the  life  of  this  mortgage.  This 
sinking  fund  should  retire  over  $500,000  of  this  loan 
before  maturity;  the  unpaid  balance  $300,000  will 
then  have  for  security  the  remaining  38,000  acres. 

Similar  plans  of  keeping  up  the  sinking  fund  are  usually 
followed  by  all  companies  of  this  character.  A  coal  mining 
company  will  set  aside  three  or  five  cents  for  each  ton  mined 
to  make  good  the  loss  in  its  coal.  A  land  company  will  njake 
certain  payments  for  each  acre  sold,  into  the  hands  of  a 
trustee. 

Sinking  funds  are  also  needful  when  bonds  are  issued  by 
companies  whose  business  is  not  plainly  of  an  enduring  charac- 
ter. Eailroad  bonds  carry  no  sinking  funds.  The  bonds  se- 
cured by  companies  operating  interurban  electric  lines,  al- 
though shorter  in  term  than  steam  railroad  bonds,  offer  this 
safeguard  in  addition  to  the  mortgage.  Certain  classes  of 
power  companies,  real  estate  companies,  and  manufacturing 
companies  can  usually  offer  to  the  investor  no  positive  assur- 
ance that  thirty  years  from  the  time  he  buys  their  bonds  the 
original  value  of  his  property  will  be  intact,  and  their  business 
will  be  prosperous.  Such  companies,  in  order  to  sell  their 
bonds,  must  provide  for  payments  to  a  trustee  from  their 
anaual  earnings  of  an  amount  sufficient  to  pay  all  or  the 
greater  part  of  their  mortgage  debts  at  maturity. 

Sinking  funds  are  divided  into  two  classes :  Jirst.  where 
the  company  makes  annual  payments  to  a  trustee;  and  the 
sgco»d  where  the  company  issues  its  bonds  under  the  serial 
plan  so  that  a  certain  part  of  the  principal  matures  each  year 
until  the  entire  amount  is  repaid  witiiin  the  term  named 


THE   KEPAYMENT   OF   BONDS  85 

in  the  mortgage.  When  the  first  plan  is  adopted  the  ques- 
tion arises,  What  shall  the  trustee  do  with  the  money  which 
is  paid  to  him  ?  Several  methods  of  disposing  of  these  funds 
are  available.  The  mortgage  securing  the  bonds  of  the  Cudahy 
Packing  Company  provides  that  an  annual  cash  sinking 
fund  of  $200,000,  beginning  November  1,  1910,  shall  be 
paid  to  the  trustee,  and  shall  be  applied  to  the  purchase  and 
cancellation  of  these  bonds  at  a  price  not  exceeding  102J 
and  accrued  interest;  or,  if  not  so  purchasable,  by  drawing 
by  lot  at  that  price.  The  mortgage  securing  the  first  mort- 
gage bonds  of  the  National  Enameling  and  Stamping  Com- 
pany provides  that  the  bonds  will  be  redeemable  at  105 
by  annual  drawings  by  the  trustee  over  a  period  of  twenty 
years  by  means  of  an  annual  sinking  fund  of  $100,000,  to 
which  will  be  added  the  interest  to  be  paid  from  time 
to  time  on  the  redeemed  bonds.  We  have  here  the  two 
methods  usually  employed  in  the  expenditure  of  the  money 
paid  into  the  sinking  fund  to  reduce  a  company's  debt: 
(1)  A  trustee  can  by  previous  arrangement  select  at 
intervals,  usually  by  lot,  a  certain  number  of  bonds  and  call 
these  in  at  a  fixed  price,  paying,  for  example,  $1,050  for 
a  $1,000  bond;  (2)  he  can  purchase  bonds  in  the  open 
market. 

The  method  of  drawing  bonds  by  lot  for  retirement  at  a 
fixed  price  is  objectionable  to  the  investor  because  he  must 
be  on  the  lookout  for  the  announcement  of  the  drawing  of 
bonds  for  retirement,  and  frequently  be  put  to  the  trouble 
of  finding  another  investment  for  the  money  which  the  cor- 
poration may  at  any  time  return  to  him.  These  drawings 
of  bonds,  however,  are  often  for  payment  at  a  good  premium 
over  the  price  paid,  and  this  premium  offsets  any  trouble  to 
which  the  investor  may  be  put  because  a  part  of  his  bonds 
are  paid  to  him  before  maturity. 

The  plan  of  purchasing  bonds  in  the  open  market  is,  from 

the  investor's  standpoint,  better  than  the  method  of  drawing 

bonds.    The  bond  market  is  less  active  than  the  stock'  market. 

Bonds  are  usually  bought  ior-  permanent  investment.     They 

7 


86  COEPORATION   FINANCE 

come  on  the  market  but  seldom  as  compared  with  stocks, 
and  in  smaller  amounts.  The  taking  of  this  small  floating 
supply,  by  the  purchases  of  the  sinking  fund  trustee,  operates 
to  maintain  a  market  price  higher  than  could  be  had  without 
such  a  regular  demand.  From  the  standpoint  of  the  corpora- 
tion, however,  aside  from  the  fact  that  the  buyers  of  these 
bonds  are  apt  to  be  well  satisfied  with  their  investment,  and 
open  to  new  offerings  of  the  same  kind,  if  the  company  must 
retire  a  certain  par  value  of  the  bonds  in  each  year  by  pur- 
chasing at  the  market  price,  it  may  sometimes  suffer  a  loss, 
because  of  the  artificially  high  price  resulting  from  the 
trustee's  purchases. 

This  objection  is  met  in  the  later  mortgages  by  pro- 
visions similar  to  those  given  above,  whereby  the  trustee  is 
obliged  to  spend  $200,000  or  $300,000  each  year  in  the  pur- 
chase of  bonds  in  the  open  market  if  these  can  be  had  at  or 
below  a  certain  price — say  105  or  106.  If  enough  bonds 
are  not  forthcoming  at  this  price,  then  the  trustee  may  draw 
a  sufficient  number  of  bonds  at  the  price  stated  in  the  mort- 
gage to  expend  the  money  in  the  sinking  fund.  This  pro- 
vision tends  to  keep  down  the  market  price  to  the  figure  at 
which  the  bonds  can  be  drawn. 

A  second  alternative  might  be  offered  to  the  trustee  in 
case  he  was  not  able  to  buy  bonds  at  the  price  named  in 
the  mortgage.  He  might  be  allowed  to  buy  other  securities 
with  the  sinking  fund.  Some  of  the  Burlington  sinking 
fund  jnortgages  contain  this  provision.  This  method,  how- 
ever, brings  into  the  sinking  fund  an  element  of  chance. 
The  bonds  bought  for  the  sinking  fund  may  rise  in  price, 
in  which  case  the  security  of  the  bondholders  will  improve, 
or  their  price  may  fall,  and  the  objects  of  the  sinking  fund, 
to  the  amount  of  the  fall,  will  not  be  achieved.  If  bonds 
are  bought  at  par  for  the  sinking  fund,  to  offset  a  debt  when 
it  comes  due,  and  if  in  the  meantime  the  price  of  the  bonds 
falls  to  90,  the  sinking  fund  lacks  ten  per  cent  of  the  sum 
needed  to  pay  the  bonds.  It  is  better,  if  any  bonds  are  to 
be  bought  for  the  sinking  fund,  that  they  should  be   the 


THE   REPAYMENT   OF   BOKDS  87 

bonds  of  the  company   which  is  building  up  the  fund,  so 
that  the  reduction  of  its  debt  may  be  certain. 

A  better  method  of  using  money  in  the  sinking  fund  has 
been  provided  in  recent  mortgages.  This  is  to  invest  the 
fund,  either  by  absolute  arrangement,  or  in  case  the  trustee 
fails  to  buy  bonds  at  a  reasonable  price,  in  improvements 
and  additions.  An  example  of  this  method  is  furnished  by 
the  following  extract  from  the  trust  indenture  securing  the 
first  mortgage  bonds  of  the  San  Diego  Consolidated  Gas  and 
Electric  Company : 

Article  Three.  Section  1.  The  company  cove- 
nants and  agrees  that  it  will  deposit  with  the  Harris 
Trust  and  Savings  Bank,  Trustee,  in  a  Depreciation 
and  Renewal  Fund  the  following  amounts  annually: 
On  the  first  day  of  June  in  each  of  the  years  1910  to 
1914,  inclusive,  a  sum  equal  to  three  per  cent  (3%), 
and  on  the  first  day  of  June  in  each  of  the  years  1915 
to  1938,  inclusive,  a  sum  equal  to  five  per  cent  (5%) 
of  the  amount,  in  par  value,  of  bonds  outstanding 
hereunder  on  the  first  day  of  October  next  preceding 
each  such  respective  deposit. 

Section  2.  The  Depreciation  and  Renewal  Fund 
shall  be  held  by  the  Harris  Trust  and  Savings  Bank, 
Trustee,  as  a  special  trust  fund,  and  the  company  shall 
be  entitled  to  withdraw  therefrom,  upon  certificates 
satisfactory  to  said  Trustee,  the  aggregate  amount  of 
the  actual  and  reasonable  cash  expenditures  made  by 
the  company  subsequent  to  April  1,  1909,  for  renewals 
and  replacements  of  its  plant,  properties,  and  equip- 
ment now  owned  or  hereafter  acquired,  exclusive  of 
customary  expenditures  for  current  repairs  and  cur- 
rent maintenance  ordinarily  chargeable  to  operating 
expenses. 

Section  3.  At  the  option  of  the  company  any  part 
of  said  Depreciation  and  Renewal  Fund  may  be  with- 
drawn, upon  certificates  to  the  Harris  Trust  and  Sav- 
ings Bank,  Trustee,  to  reimburse  the  company  (a) 
for  its  actual  and  reasonable  cash  expenditures  for 
permanent  extensions  and  additions  of  and  to  its 
plants,  properties,  and  equipment  .  .  .  provided  such 
expenditures    shall    not    have    been    previously    made 


88  COEPOEATION   FINANCE 

the  basis  for  the  issuance  of  bonds  hereby  secured; 
or  (b)  for  its  expenditures  made  in  the  purchase  or 
redemption  of  bonds  hereby  secured  at  a  price  not 
exceeding  par,  accrued  interest,  and  a  premium  of  five 
per  cent  upon  the  principal  thereof. 

Here  is  a  sinking  fund  provision,  under  another  name, 
which  gives  the  company  the  option  of  either  buying  its 
bonds  at  105  and  accrued  interest,  or  of  spending  a  certain 
amount  upon  its  plant.  When  the  business  of  the  borrowing 
company  is  secure,  as  in  this  case,  and  if  the  trustee  is  vigilant 
in  supervising  the  expenditure  of  the  sinking  fund,  the  security 
of  the  bonds  can  be  conserved  by  the  investment  of  the  sinking 
fund  on  the  improvement  of  the  property.  The  value  of  the  se- 
curity will  be  increased  at  a  more  rapid  rate  under  this  method 
than  the  rate  at  which  the  liabilities  of  the  company  will 
be  decreased  by  its  purchases  of  its  own  bonds.  This  method 
does  not  apply  to  companies  with  wasting  assets  or  to  those 
whose  future  is  uncertain. 

The  methods  of  disposing  of  bonds  bought  by  the  trustee 
for  the  sinking  fund  are  as  follows:  (1)  they  may  be  can- 
celed as  purchased  and  delivered  by  the  trustee  to  the  com- 
pany— the  usual  plan;  (2)  they  may  be  kept  in  the  sinking 
fund  as  an  obligation  of  the  company,  and  the  interest  paid 
into  the  sinking  fund  as  an  addition  to  the  regular  sinking 
fund  appropriations — the  retirement  of  the  bonds  proceeding 
at  an  increasing  rate  becaus'e  of  the  addition  of  the  interest 
on  the  bonds  in  the  sinking  fund  to  the  appropriations  from 
income  for  the  benefit  of  the  fund;  and  (3)  the  bonds  held 
in  the  sinking  fund  may  be  sold  for  the  benefit  of  the 
company. 

The  use  of  the  third  method  is  shown  by  the  trust  in- 
denture of  the  San  Diego  Consolidated  Gas  and  Electric 
Company,  already  referred  to,  which  states  that  "  said  trus- 
tee upon  the  written  request  of  the  company  shall  hold  un- 
canceled in  said  Depreciation  and  Renewal  Fund  any  bonds 
so  purchased,  and  the  company  may  with  the  approval  of 
said  trustee  sell  any  or  all  such  bonds  so  held,  in  which  case 


THE   EEPAYMENT   OF   BONDS  89 

the  proceeds  from  the  sale  thereof  shall  be  held  and  applied 
according  to  the  provisions  of  this  Article."  This  method 
of  disposing  of  bonds  in  the  sinking  fund  is  available  only 
for  companies  whose  assets  and  business  are  permanent. 

A  method  of  managing  sinking  funds  which  is  as  yet 
little  used  is  that  of  the  serial  bond.  This  plan  has  been 
followed  by  several  leading  bond  houses  who  have  sold  large 
amounts  of  serial  bonds,  largely  because  they  have  been  able, 
by  employing  the  method  of  issuing  bonds  in  series,  to  sell 
high  interest  bonds  of  mining,  lumber,  and  manufacturing 
companies,  where  the  security,  without  the  protection  of 
serial  payment,  would  be  too  small.  Friends  of  the  serial 
bond  plan  claim  that  "  a  safe  margin  of  security  on  a  bond 
issue  at  the  time  of  its  sale  is  by  no  means  a  guaranty  that 
the  same  margin  will  exist  during  the  life  of  the  bond. 
Physical  depreciation,  changes  in  industrial  conditions, 
changes  in  tariff,  and  transportation  rates — any  one  of  a 
large  number  of  causes  may  impair  the  security,  and  the 
chances  of  business  may  impair  the  security  of  the  bonds. 
The  serial  plan  protects  the  investor  against  these  accidents. 
Under  this  plan,  a  portion  of  the  principal  is  paid  off  each 
year  and  no  portion  of  the  security  released.  The  pa3rment8 
are  graded  according  to  the  net  earnings  of  the  property,  but 
are  considerably  larger  than  ordinary  sinking  fund  payments. 
At  each  anniversary,  upon  payment  of  this  installment  of 
principal,  the  margin  of  security  automatically  rises."  It  is 
also  claimed  that  the  borrowing  company,  by  the  operation 
of  the  plan,  is  encouraged  to  keep  the  income  from  the  prop- 
erty in  the  business  in  order  to  meet  the  annual  installments. 
"  He  also  finds  it  to  his  own  advantage  to  maintain  his 
property  at  a  high  standard.  As  his  own  capital  invested  in 
the  property  increases,  there  is  an  unconscious  influence 
which  tends  toward  promptness  in  meeting  interest  payments, 
taxes,  and  other  charges."  ^ 

*  It  is  fair  to  Peabody,  Houghteling  &  Co.,  from  one  of  whose  cir- 
culars this  quotation  is  taken,  to  state  that  in  offering  so-called  low- 
grade  bonds,  bearing  high  rates  of  interest,  they  not  only  insist  upon 


90  COKPOKATION   FINANCE 

The  serial  bond  plan  has  this  advantage  from  the  stand- 
point of  the  bond  house,  that  it  is  able  to  sell  the  bonds 
maturing  at  an  early  date  on  much  the  same  terms  as  com- 
mercial paper  is  sold,  or  short  term  notes  of  corporations,  to 
financial  institutions  with  surplus  funds  for  short  time  in- 
vestment. It  is  possible,  in  this  way,  it  is  claimed,  to  obtain 
a  much  broader  market  and  readier  sale  for  serial  bonds 
than  for  long  maturities.  The  objection  to  the  serial  bond 
plan  from  the  company's  standpoint  is  that  its  entire  surplus 
income  is  likely  to  be  absorbed  in  paying  off  its  debt  and  the 
stockholder  will  receive  nothing.  It  is  evidently  an  exag- 
gerated sinking  fund  which  aims  to  absorb  most  of  the  avail- 
able revenue  of  the  property  in  the  extinction  of  its  debt. 

the  serial  plan  of  issue  but  also  require  that  the  owners  should  have 
invested  a  substantial  amount  in  the  property,  seldom  undertaking 
to  purchase  a  sufficient  amount  of  bonds  to  provide  for  the  entire  con- 
struction of  the  property. 


CHAPTER    VIII 

THE   ISSUE   OF  STOCK 

Whenever  possible,  for  reasons  which  we  have  already 
given,  the  promoters  of  a  new  corporation  will  include  a  bond 
issue  in  their  plan  of  capitalization  in  order  to  secure  for 
themselves  or  their  successors  a  larger  dividend  per  share 
than  could  be  received  if  stock  were  used  to  obtain  the  neces- 
sary funds.  Certain  kinds  of  industries,  however,  do  not 
furnish  a  satisfactory  basis  for  a  bond  issue,  at  least  until 
their  success  has  been  well  established,  and  then  only  to  a 
moderate  proportion  of  the  value  of  their  assets.  The  bonds 
of  the  class  of  companies  known  as  industrials  including 
manufacturing,  mining,  and  trading  companies  and  also, 
under  some  classifications,  companies  engaged  in  the  sale  of 
gas  and  electric  power,  are  seriously  restricted  at  the  outset 
in  their  issue  of  bonds  as  a  means  of  obtaining  funds.  The 
bond  buyer  surrenders  all  chance  of  participation  in  the 
increased  earnings  of  a  company  in  exchange  for  the  guar- 
antee of  a  fixed  rate  of  return  upon  his  investment.  If  this 
guarantee  is  doubtful,  the  security  of  the  investment  is  dis- 
counted in  the  price  of  the  bonds,  if  indeed  these  can  be 
sold  at  any  price.  The  bonds  of  industrial  corporations, 
especially  manufacturing  companies,  are  unpopular  with  in- 
vestors for  reasons  which  have  already  been  indicated  in 
some  detail.  Companies  operating  in  these  industries  can 
issue  bonds  to  a  limited  amount,  and  under  special  safe- 
guards, only  after  their  business  has  been  well  established. 
At  the  outset,  however,  this  form  of  security  is  not  usually 
available  to  them. 

91 


92  COKPOKATION   FINANCE 

The  use  of  bonds  in  the  plan  of  capitalizing  a  new  com- 
pany to  be  formed  by  the  consolidation  of  previously  exist- 
ing corporations,  is  especially  unpopular.  The  owners  of 
these  constituent  companies  are  not  likely  to  consent  to  have- 
the  properties  which  they  turn  in  to  the  new  company 
subjected  to  the  lien  of  a  mortgage  to  secure  bonds  to  be 
sold  to  the  general  investor.  They  will  insist  that  most  of 
these  bonds  shall  be  directly  issued  in  exchange  for  their 
property,  leaving  only  a  small  amount  to  be  sold.  Further- 
more, the  issuing  of  bonds  materially  lessens  the  value  of 
the  stocks  of  the  new  company,  out  of  which  promoters  and 
bankers  are  to  get  their  profits.  Especially  do  stock  values 
suffer  if  bonds  are  issued  to  a  substantial  proportion  of 
the  value  of  the  plants  of  the  constituent  companies.  In 
the  formation  of  the  industrial  combinations,  bonds  were 
very  little  employed.  The  chief  exception  was  the  United 
States  Steel  Corporation,  where  Mr.  Andrew  Carnegie  was 
in  a  position  to  exact  hard  terms  from  the  promoters,  and 
received  for  himself  and  associates  $300,000,000  of  first 
mortgage  bonds.  In  most  cases  the  promoters  of  these  enter- 
prises went  to  considerable  trouble  to  pay  off  all  the  debts, 
both  funded  and  unsecured,  for  which  the  various  constituent 
companies  were  responsible,  because  they  considered  it  of  the 
utmost  importance,  in  view  of  the  necessity  of  appealing  to 
the  public  to  buy  the  stocks  of  these  companies,  that  the 
dividends  on  these  stocks  should  not  be  jeopardized  by  the 
claims  of  bondholders. 

When  bonds  cannot  be  issued,  either  because  the  industry 
does  not  furnish  adequate  security  for  a  bond  issue,  or  be- 
cause of  the  necessity  of  presenting  an  attractive  stock  propo- 
silion  to  the  investor,  the  promoter,  in  formulating  his  finan- 
cial plan,  falls  back  upon  the  issue  of  preferred  stock.  Most 
of  the  preferred  stocks  dealt  in  on  the  public  exchanges,  and 
now  outstanding  as  original  issues,  were  put  out  by  the 
industrial  combinations.  There  are  numerous  issues  of  pre- 
ferred stocks  by  railroads  but  most  of  these  were  put  out 
in  connection  with  reorganizations,  in  exchange  for  bonds 


THE   ISSUE   OF   STOCK  93 

whose  interest  could  not,  at  the  time,  be  earned.  Preferred 
stock  has  been  little  used  as  original  issues  by  promoters  of 
railroad  companies.  Preferred  stock  has  been  quite  largely 
used  by  public  service  corporations,  but  most  of  these  issues 
are  not  dealt  in  on  the  exchanges.  We  shall  find  the  methods 
employed  in  the  original  issue  of  preferred  stock  best  illus- 
trated in  the  practice  of  the  trusts. 

The  Railway  and  Industrial  Supplement  published  quar- 
terly by  the  Commercial  and  Financial  Chronicle  gives  a 
total  of  101  important  issues  of  preferred  stocks  by  indus- 
trial companies,  most  of  them  consolidations.  Most  of  this 
stock  was  given  in  exchange  for  the  stocks  or  property  of 
enterprises  which  entered  the  consolidations.  In  nearly  every 
case  preferred  stock  was  also  sold  for  cash  to  equip  the  new 
company  with  working  capital,  or  to  provide  funds  for  tlie 
payment  of  owners  or  stockholders  who  would  not  accept 
stock  in  the  new  company.  An  examination  of  the  list  of 
preferred  stock  issues  shows  certain  salient  facts  which  may 
be  taken  as  typical  of  this  kind  of  security. 

In  most  cases  preferred  stock  is  made  cumulative  as  to 
dividends.  Cumulative  preferred  stock  gives  to  its  holders 
a  claim  on  earnings  which  is,  in  some  respects,  similar  to 
that  conferred  by  the  possession  of  mortgage  bonds.  All 
unpaid  dividends  on  such  stocks  must  be  paid  before  the 
common  stock  can  receive  any  share  of  profits.  Just  as 
unpaid  interest  accumulates  to  the  disadvantage  of  junior 
securities,  so  the  preferred  stockholder  can  assert  his  prior 
claim  to  profits,  as  against  the  common  stockholder,  up 
to  the  amount  represented  by  the  rate  of  dividends  on 
the  number  of  shares  which  he  holds,  times  the  number  of 
years  the  stock  has  been  in  existence.  If  the  profits  are  only 
sufficient  to  pay  seven  per  cent  on  the  par  value  of  the  pre- 
ferred stock,  if  that  is  the  rate  named  in  the  contract  between 
the  stockholder  and  the  corporation,  and  in  case  the  directors 
decide  to  distribute  these  profits,  the  holder  of  cumulative 
preferred  stock  will  receive  seven  per  cent,  while  the  com- 
mon stockholder  will  receive  nothing. 


94  COKPOKATION   FINANCE 

Unless  the  cumulative  feature  is  inserted,  however,  the 
advantage  of  the  preferred  stockholder  over  the  common 
stockholder  is  more  apparent  than  real.  If  preferred  stock 
is  noncumulative,  the  finances  of  the  company  may  be  so 
administered  as  to  place  the  preferred  and  the  common  stock- 
holder on  a  footing  of  exact  equality.  The  corporation 
always  needs  money  for  improvements  and  extensions,  and 
the  directors  may  find  a  variety  of  excellent  reasons  for  re- 
fusing to  pay  dividends  on  the  preferred  stock  until  the 
company  is  strong  enough  to  begin  paying  both  preferred 
and  common  stock  dividends  at  the  same  time.  Any  money 
which  may  be  reserved  for  the  preferred  stockholder  and 
invested  in  the  business  will  accrue,  in  part  at  least,  to  the 
benefit  of  the  common  stockholder,  and  the  temptation  is 
strong  under  these  circumstances  to  sacrifice  the  preferred 
stockholder.  If,  however,  the  preferred  stock  is  made  cumu- 
lative, and  if  the  earnings  permit,  the  preferred  dividends 
must  be  paid.  They  would  otherwise  accumulate  against 
the  common  stock  whose  value  might  be  entirely  extinguished 
because  of  the  hopelessness  that  the  company  would  ever 
be  able  to  discharge  the  arrears  of  accumulated  preferred 
dividends. 

The  existence  of  the  cumulative  feature  in  the  preferred 
stocks  of  the  industrial  combinations  explains  the  persistence 
with  which  their  directors  have  adhered  to  a  liberal  dividend 
policy,  even  in  the  face  of  depression  when  prudent  manage- 
ment would  seem  to  demand  that  the  resources  of  the  com- 
pany be  conserved.  Even  with  weak  companies  of  this  class, 
plainly  in  need  of  capital  for  improvements,  the  practice  of 
paying  preferred  dividends  has  been  almost  universal.  The 
directors  might,  to  the  great  physical  benefit  of  the  corpo- 
rations themselves,  have  allowed  these  preferred  claims  to 
accumulate  to  any  extent.  They  might  have  invested  the 
money  in  improvements,  piling  up  a  large  surplus  over  their 
liabilities.  Such  a  policy,  if  continued  for  a  number  of  years, 
would  have  placed  the  preferred  stocks  of  everyone  of  these 
companies  in  a  position  where  their  dividends  could  be  paid 


THE   ISSUE   OF   STOCK  95 

without  question,  no  matter  what  the  condition  of  trade. 
The  payment  of  dividends  upon  the  common  stock,  under 
such  a  policy  would,  however,  have  been  placed  permanently 
out  of  the  question.  In  five  years,  with  seven  per  cent  cumu- 
lative preferred  ahead  of  it  on  which  no  dividends  were  paid, 
the  common  stock  would  have  been  buried  under  thirty-five 
per  cent  of  unpaid  preferred  dividends.  These  back  div- 
idends, in  most  cases,  even  under  the  most  favorable  cir- 
cumstances, with  the  liberal  capitalization  of  the  industrials, 
could  not  be  paid  off  while,  at  the  same  time,  the  regular 
dividend  on  the  preferred  was  being  maintained,  in  less  than 
five  years  more.  A  policy  of  investing  profits  in  improve- 
ments at  the  expense  of  the  cumulative  preferred  stockholder, 
means  that  the  common  stockholder  must,  in  the  usual  run 
of  events,  be  kept  out  of  any  dividends  for  a  long  time,  per- 
haps until  the  par  value  of  his  stock  is  reduced. 

Such  a  policy  would  make  the  common  stock  entirely 
unattractive  as  a  purchase  if  it  were  announced  at  the  out- 
set, and  after  the  common  stock  had  once  been  purchased  in 
good  faith  on  the  promise  of  dividends  as  soon  as  they  were 
earned,  the  directors  could  not,  in  fairness,  extinguish  this 
value  by  allowing  dividends  to  accumulate  on  the  preferred 
stock,  no  matter  how  much  this  course  might  be  demanded 
by  considerations  of  conservative  management.  If  the  fail- 
ure to  pay  dividends  on  the  common  stock  resulted  from 
causes  outside  of  their  control,  an  overestimate  of  profits  or 
an  underestimate  of  expenses,  directors  could  not  be  blamed 
by  the  common  stockholder,  but  the  adoption  of  a  policy  of 
reserving  profits  for  the  benefit  of  the  company,  although 
it  might  be  justifiable  and  even  necessary,  when  only  common 
stock  had  been  issued,  the  effect  of  which  would  be  to  make 
the  payment  of  dividends  on  the  common  stock  only  a 
remote  possibility,  would  have  subjected  the  directors  to 
severe  criticism.  No  matter  how  necessary  the  postponement 
of  preferred  dividends  might  be  when  judged  by  the  stand- 
ard of  investment  requirements,  so  far  as  concerns  the  divi- 
dends on  cumulative  preferred  stock,  this  course  is  usually 


96  COKPORATION   riNANCE 

impossible.  If  dividends  on  cumulative  preferred  stock  have 
been  earned  in  any  year,  the  practice  is  to  pay  them. 

In  a  few  flotations,  an  attempt  has  been  made  to  reconcile 
the  necessity  of  conservatism  in  the  distribution  of  profits 
with  the  demands  of  the  preferred  stockholder  that  he  be 
insured  in  a  prior  claim  to  dividends,  by  providing  that  the 
cumulative  feature  shall  not  begin  at  once,  but  that  the 
stock  shall  be  made  noncumulative  for  perhaps  three  or  five 
years,  and  that  when  accumulation  begins  in  the  case  of  a 
seven-per-cent  preferred  stock,  for  example,  it  shall  start 
with  two  per  cent  and  increase  in  an  ascending  scale.  It 
is  difficult  to  sell  preferred  stock  with  such  provisions  in- 
cluded in  the  contract  with  the  corporation,  since  they 
amount  to  a  plain  declaration  to  whoever  buys  the  stock  that 
the  company  may  not  pay  him  any  dividends  for  perhaps  five 
years,  and  that,  at  the  end  of  that  time,  they  may  pay  him 
dividends  only  on  the  ascending  scale  of  accumulation. 

The  difficulties  in  the  administration  of  a  company's  in- 
come account  which  result  from  the  existence  of  cumulative 
preferred  stock  can  only  be  avoided  by  limiting  the  amount 
originally  issued  to  the  principal  sum  on  which  the  surplus 
revenues  of  the  company  will  be  sufficient  to  pay  a  dividend, 
while  at  the  same  time  leaving  a  balance  sufficient  for  the 
current  requirements  of  the  business,  and  for  a  dividend  on 
the  common  stock  within  a  reasonable  time.  While  this  re- 
quirement is  sound  in  theory,  if  we  may  judge  from  the 
practice  of  American  corporations  which  include  cumulative 
preferred  stock  as  a  part  of  their  original  plans  of  capitaliza- 
tion, it  is  found,  in  most  cases,  impracticable. 

The  rate  of  dividend  established  on  preferred  stocks  is 
usually  either  six  or  seven  per  cent  on  industrials,  and  five 
per  cent  on  public  service  corporations.  Railroad  preferred 
stocks,  issued  in  reorganizations,  usually  pay  four  per  cent. 
The  varying  rates  of  preference  in  stocks  issued  by  these 
different  classes  of  companies  represent  the  relative  standing 
of  these  investments.  In  only  a  few  cases,  do  we  find  pre- 
ferred dividends  higher  than  seven  per  cent.     The  first  pre- 


THE   ISSUE   OF   STOCK  97 

ferred  stock  of  the  United  States  Eubber  Company  and  the 
preferred  stock  of  the  Virginia-Carolina  Chemical  Company- 
pay  eight  per  cent.  Out  of  101  issues  of  preferred  stocks 
only  fourteen  paid  over  seven  per  cent.  With  the  scale  of 
capitalization  adopted  by  most  companies,  involving  large 
issues  of  cumulative  preferred  stock,  and  basing  our  conclu- 
sions on  the  experience  of  these  companies  during  the  last 
ten  years,  a  cumulative  rate  of  dividend  of  seven  per  cent 
is,  for  the  average  company,  too  high  for  the  security  of 
common  stock.  In  fixing  the  high  rate  of  seven  per  cent, 
the  effect  has  been  in  many  cases  to  absorb  the  surplus  earn- 
ings which,  in  reasonable  certainty,  would  be  available  for 
the  preferred  stock,  and  to  leave  the  common  stock  only 
the  chances  and  uncertainties  of  profits. 

Preferred  stock  may  be  cumulative  fiot  merely  as  to  divi- 
dends, but  also  as  to  assets.  Charters  sometimes  provide, 
as  does  the  charter  of  the  American  Car  &  Foundry  Com- 
pany, that  the  board  of  directors  shall  have  power,  without 
the  assenting  vote  of  the  stockholders,  to  sell,  or  otherwise 
dispose  of,  any  or  all  of  the  property  of  the  company.  When 
these  large  powers  are  given  to  the  board  of  directors,  the 
following  situation  may,  conceivably,  arise:  The  company 
may  be  earning  barely  enough  to  pay  dividends  on  the  cumu- 
lative preferred  stock.  Perhaps  preferred  dividends  may 
have  been  passed  for  several  years,  piling  up  against  the 
common  stock,  which  may,  as  a  result,  have  but  a  nominal 
value.  Some  outside  interest,  seeing  a  chance  for  a  specu- 
lative profit  may  buy  up  this  low-priced  common  stock,  elect 
a  board  of  directors  favorable  to  his  plan,  and  sell  the  prop- 
erty of  the  company.  In  case  such  a  sale  is  made,  and 
unless  the  preferred  stock  is  also  given  preference  in  the  dis- 
tribution of  assets,  the  common  stock  will  participate  equally 
with  the  preferred  in  the  proceeds  of  the  sale,  although  its 
market  value,  based  on  its  prospects  of  dividends,  was  small. 
In  order  to  guard  against  such  a  contingency,  which,  it  must 
be  admitted,  is  somewhat  remote,  it  is  not  unusual  to  find 
preferred  stock  made  cumulative  both  as  to  assets  as  well  as 


98  COKPOKATION   FINANCE 

dividends.  A  provision  in  the  certificate  of  incorporation 
which  gives  this  preference  is  worded  somewhat  as  follows :  ^ 

In  the  event  of  any  liquidation  or  dissolution  or 
winding  up  (whether  voluntary  or  otherwise)  of  the 
corporation,  then,  before  any  amount  shall  be  paid  to 
the  holders  of  common  stock,  the  holders  of  preferred 
stock  shall  be  entitled  to  be  paid  in  full  for  the  par 
amount  of  their  shares,  and  in  addition  thereto  all 
arrears  of  dividends — that  is  to  say,  an  amount  suffi- 
cient, with  the  dividends  actually  paid,  to  make  seven 
per  cent  for  each  year;  and  after  the  payment  to  the 
holders  of  the  preferred  stock  of  such  par  value  and 
arrears  of  dividends,  the  remaining  assets  and  funds 
shall  be  divided  and  paid  to  the  holders  of  common 
stock,  pro  rata,  according  to  their  respective  shares. 

Out  of  the  issues  already  referred  to,  thirty-seven  have  these 
provisions.  The  dissolution  of  corporations  almost  always 
follows  bankruptcy  proceedings  which  result  in  the  sale  of 
all  the  property  for  the  benefit  of  creditors,  and  the  prefer- 
ence as  to  assets  given  to  the  preferred  stockholder  can  hardly 
be  regarded  as  a  practical  safeguard.  The  end  desired, 
namely,  the  protection  of  the  preferred  stockholder  against 
speculative  dissolution  of  the  company  can  be  as  well  attained 
by  providing  that  the  directors  may  not  dispose  of  the  prop- 
erty of  the  company  without  the  consent  of  two  thirds  or 
three  fourths  of  both  classes  of  stock.  Such  a  provision  does 
not  discredit  the  common  stock,  while  the  provision  that  the 
preferred  stock  shall  be  cumulative  as  to  assets  as  well  as 
to  dividends  is  apt,  if  the  common  stockholder  looks  into  it, 
to  dishearten  him. 

It  is  the  danger  of  bankruptcy  against  which  the  pre- 
ferred stockholder  is  particularly  interested  to  guard  by  lim- 
iting the  ability  of  the  directors  to  incur  mortgage  indebt- 
edness. He  accomplishes  this  by  a  provision,  similar  to  the 
following,  inserted  in  the  certificate  of  incorporation  where 

1  Extract  from  the  Amended  Certificate  of  the  International  Har- 
vester Company. 


THE   ISSUE   or   STOCK  99 

preferred  stock  is  issued,  taken  from  the  articles  of  incor- 
poration of  the  Crucible  Steel  Company : 

The  corporation  shall  not  mortgage  any  property 
except  by  purchase-money  mortgage,  without  the  writ- 
ten assent,  or  pursuant  to  the  affirmative  vote  in  per- 
son or  by  proxy,  at  any  meeting  called  in  accordance 
with  the  by-laws,  of  the  holders  of  at  least  two  thirds 
of  its  preferred  stock  then  issued  and  outstanding. 

The  preferred  stockholder  may  not  be  satisfied  with  pref- 
erence in  dividends  and  assets.  He  may  also  demand  the 
right  to  participate  with  the  common  stockholder  in  dis- 
tributed profits  after  his  preferred  dividends  have  been  paid. 
When  such  participation  is  allowed,  it  is  usual  to  provide 
for  a  certain  dividend  upon  the  common  stock,  say  six  or 
seven  per  cent,  and  that  the  preferred  stock  shall  thereafter 
share  with  the  common  on  some  agreed  basis.  The  Asso- 
ciated Merchants  Company,  for  example,  agrees  that  for 
every  one  per  cent  dividend  paid  in  excess  of  seven  per  cent 
one  half  of  one  per  cent  is  to  go  to  the  preferred  stock.  Such 
a  provision  is  unusual.  Out  of  the  list  under  examination 
we  find  only  three  preferred  stocks  which  are  made  par- 
ticipating. 

Another  method  of  allowing  preferred  stock  the  benefit 
of  cumulative  preference  in  dividends,  combined  with  a  large 
share  in  contingent  profits,  is  to  make  the  preferred  stock 
convertible  into  common  stock  on  an  agreed  basis,  usually 
at  par.  The  Associated  Merchants  Company  and  the  Do- 
monion  Coal  Company  are,  however,  the  only  examples  in  the 
list  above  referred  to  where  this  privilege  has  been  given. 
The  position  of  the  holder  of  cumulative  six-  or  seven-per- 
cent stock,  issued  on  a  liberal  scale,  is  far  superior  to  that 
of  the  common  stock,  and  the  chances  that  conversion  would 
have  proved  advantageous  are  so  remote  as  to  render  the 
inducement  of  the  privilege  of  converting  into  common  stock 
of  little  value  to  an  intending  purchaser  of  preferred  stock. 
The  inclusion   of  this  feature,  moreover,  would   make  the 


100  COEPOEATION  FINANCE  , 

4 

common  stock  less  attractive  to  the  investor,  since  it  is  already- 
subjected  to  the  serious  handicap  of  a  high  cumulative  div- 
idend. 

In  original  issues  of  preferred  stock,  special  voting 
powers  may  be  given  to  this  security.  The  first  preferred 
stock  of  the  Eock  Island  Company,  for  example,  elects  a 
majority  of  the  board  of  directors.  It  is  unusual  to  find 
this  provision.  The  rule  is  that  preferred  and  common 
stock,  when  both  are  issued  at  the  same  time,  have  equal 
voting  power.  A  wholesome  provision  for  the  protection  of 
the  preferred  stockholder  is  that  the  common  stock  shall 
forfeit  its  vote  whenever  preferred  dividends  remain  unpaid 
for  the  space  of  a  year.  A  variety  of  other  safeguards  and 
restrictions  upon  the  corporation  issuing  preferred  stock  are 
used  but  not,  as  a  rule,  with  original  issues.  They  will  be 
taken  up  in  detail  in  a  later  chapter. 

Common  stock  is  a  feature  of  every  financial  plan.  When 
no  public  flotation  is  expected,  the  amount  of  common  stock 
is  a  matter  of  no  consequence.  It  usually  represents  the 
controlling  interest,  and  is  sometimes  placed  at  a  nominal 
figure.  In  public  flotations,  however,  common  stock  is  usually 
issued  to  capitalize  anticipated  earnings.  It  is  supposed  to 
represent  the  future  profits  of  the  property.  The  industrial 
trusts,  for  example,  issued  preferred  stock  for  the  value  of  the 
separate  companies  before  consolidation.  The  common  stock 
was  supposed  to  express  the  economies  and  profits  accom- 
plished by  the  consolidation,  as  well  as  those  arising  out  of 
the  natural  growth  of  the  business.  Common  stock  is  usually 
sold  at  a  low  figure,  liberal  representations  concerning  antic- 
ipated earnings  being  made  to  influence  its  purchase.  These 
representations  are  not  often  realized. 

The  practical  limit  of  the  amount  of  common  stock  issued 
by  a  majority  of  the  companies  has  been  the  amount  of  stock 
from  which  the  largest  amount  of  net  returns  over  expenses 
could  be  realized  by  those  into  whose  hands  the  stock  came 
in  exchange  for  property  sold  to  the  company.  For  example, 
if  $5,000,000  could  be  sold  at  eighty,  and  $15,000,000  could 


THE   ISSUE   OF   STG€R  101 

be  sold  at  forty,  the  second  figure  Vdll  be '  the  'one  selected 
The  money  value  of  stock  sold  to  the  public  increases  at  a 
more  rapid  rate  than  the  increase  in  the  amount  of  stock 
offered.  It  might  seem  that  since  the  common  stock  rep- 
resents the  entire  value  of  the  company  over  the  claims  of 
the  bondholders  and  the  preferred  stockholder,  it  would  be  a 
matter  of  indifference  to  the  market  value  of  the  stock  whether 
it  be  fixed  at  $5,000  or  $5,000,000.  Such,  however,  is  not 
the  case.  To  the  mind  of  the  average  buyer  of  stock,  the 
figures  printed  on  the  face  of  the  certificate  convey  a  pecuniary 
suggestion,  an  idea  of  actual  value.  The  more  of  these  certif- 
icates that  are  issued,  up  to  the  point  where  it  becomes  ap- 
parent that  the  company  will  never  be  able  to  pay  dividends 
on  its  stock,  the  larger  will  be  the  amount  of  money  for  which 
they  can  be  sold.  This  fact  explains  the  excessive  capitaliza- 
tion of  corporations  whose  stock  is  to  be  offered  to  the  public. 
Up  to  the  present  time,  no  effective  means  has  been  devised 
to  check  this  practice,  save  in  a  few  states  which  control  the 
security  issues  of  public  service  corporations. 

In  conservative  flotations,  where  it  is  not  intended  to  im- 
mediately dispose  of  the  common  stock,  and  where  those  who 
sell  their  property  to  the  corporation  expect  to  retain  con- 
trol for  a  considerable  time,  holding  their  stock  as  an  invest- 
ment, a  different  standard  is  adopted.  By  such  companies, 
the  amount  of  common  stock  is  fixed  at  a  figure  on  which 
dividends,  after  a  few  years  of  successful  operation  of  the 
company,  can  probably  be  paid.  Common  stock  is  frequently 
given  to  engineers  who  may  be  put  in  charge  of  a  property 
during  its  early  stages,  with  a  view  to  increasing  their  dili- 
gence. It  may  also  be  given  to  banks  and  trust  companies 
as  a  bo^us  for  the  loans  which  they  make  a  new  company. 
If  the  amount  of  stock  issued  was  excessive  and  out  of  all 
reason,  as  it  has  been  in  the  case  of  many  large  public  flota- 
tions, there  would  be  no  purpose  in  holding  it.  Indeed,  the 
desire  would  be  to  dispose  of  it  as  soon  as  possible.  With  a 
conservative  capitalization,  however,  it  is  frequently  possible 
to  make  more  money  by  retaining  the  stock  than  by  im- 
.8 


102  0()RPORATION  FINANCE 

mediately  selling  it.  '  'Corporations  promoted  by  established 
banking  houses  are  also  conservative  in  their  common  stock 
capitalization.  These  bankers  have  a  reputation  to  maintain 
which  is  indeed  their  chief  asset.  They  cannot  afford  to  risk 
a  flotation  with  whose  bad  results  they  may  at  some  future 
time  be  reproached  by  some  of  those  whom  they  may  have 
victimized. 

As  a  general  proposition,  if  a  corporation  pays  four  per 
cent  on  its  common  stock  after  five  years'  operation,  its  com- 
mon stock  capitalization  must  be  regarded  as  conservative.  It 
is  unreasonable  to  expect  common  dividends  at  once  or  before 
an  adequate  reserve  of  earnings  has  been  established,  but 
within  five  years,  if  the  business  of  the  company  is  sound, 
if  it  is  properly  managed,  and  with  normal  conditions  of 
demand,  it  should  pay  four  per  cent  on  its  common  stock. 

Note — I  have  designedly  omitted  all  discussion  of  the  question  of  over- 
capitalization. This  is  a  point  still  in  controversy,  and  likely  to  be  un- 
settled for  several  years.  In  a  text  book,  its  discussion  would  be  unprofit- 
able. In  order  to  avoid  the  suspicion  of  shirking  a  vital  issue,  I  may 
state,  as  my  own  opinion,  that  irrespective  of  the  merits  of  this  method  of 
settlement,  the  final  solution  of  the  problem  will  be  found  in  a  limitation 
of  security  issues,  especially  by  pubUc  service  corporations,  to  the  cash  cost 
or  fair  value  of  property  constructed  or  purchased.  This  fair  value  will 
be,  moreover,  determined  not  by  the  directors  of  the  purchasing  company 
but  by  some  disinterested  public  authority.  In  my  opinion,  this  method 
of  restricting  security  issues  which  are  to  be  sold  to  the  public,  would  not 
interfere  with  the  development  of  any  legitimate  enterprise,  and  would 
operate  to  increase  the  security  of  investments. 


CHAPTER   IX 
METHODS  OF  PAYING  FOR  STOCK 

We  take  up  next  the  methods  of  paying  for  stock.  We 
shall  first  consider  the  cases  in  which  the  stock  is  paid  for 
in  whole  or  in  part  by  cash.  Stock  sold  bv  the  corporation 
for  cash  is  of  two  classes,  assessable  or  full  paid,  according 
as  the  payment  is  full  or  partial.  Full  paid  stock  may  be 
paid  for  at  one  time  or  in  installments.  When  stock  is  issued 
for  work  of  construction,  such  as  the  building  of  a  new  line 
of  railroad  or  the  erection  of  a  mill,  the  company's  payments 
are  protracted  over  a  considerable  period.  There  is  no  pur- 
pose, therefore,  in  securing  the  full  amount  of  the  subscrip- 
tion at  one  time.  The  money  is  arranged  to  be  paid  as  it 
is  needed,  the  payments  sometimes  being  extended  over  a  year 
or  even  longer.  The  practice  in  such  cases  is  not  to  pay 
dividends  on  the  new  stock  until  the  entire  amount  has  been 
paid  up,  but  to  allow  the  subscribers  interest  on  their  install- 
ments as  these  are  paid  into  the  treasury  of  the  corporation. 

Assessable  stock  is  of  a  different  character.  Here  the 
payment  is  made  in  cash  and  in  promises  to  pay  cash. 
The  subscription  to  $10,000  of  stock,  par  value  $100,  "ten 
per  cent  paid,"  will  be  $1,000  in  cash,  and  $9,000  in  a  promise 
to  pay  that  amount  when  called  for  by  the  board  of  directors. 
The  advantages  of  this  form  of  stock,  viewed  from  the  stand- 
point of  the  corporation,  are  considerable.  In  the  first  place, 
the  issue  of  assessable  stock  makes  it  possible  for  a  company 
embarking  in  a  new  enterprise  to  guard  against  underestimates 
of  the  cost  of  construction.  If,  for  example,  an  interurban 
railroad  is  estimated  to  cost  $500,000,  and  subscriptions  to 

103 


104  COEPORATION  FINANCE 

$500,000  are  secured,  and  supposing,  as  frequently  happens, 
that  the  cost  is  raised  by  unforeseen  circumstances  to  $750,- 
000,  it  then  becomes  necessary  for  the  officers  of  the  company 
to  apply  to  the  stockholders  for  additional  subscriptions  which 
they  can  usuall})  obtain  only  by  issuing  preferred  stock  which 
may  not  have  been  contemplated  in  the  original  plan.  Under 
such  circumstances,  however,  it  is  practically  impossible  to 
persuade  stockholders  to  subscribe  to  an  additional  amount  of 
common  stock.  They  are  apt  to  lose  confidence  in  the  man- 
agers of  the  enterprise  whom  they  hold  responsible  for  the 
mistakes  in  the  estimates  of  construction  cost,  and  may  even 
oust  the  directors  from  office  and  put  in  a  new  control.  The 
writer  once  heard  a  banker  who  had  been  interested  in  pro- 
moting an  iron  furnace  enterprise  in  Eastern  Pennsylvania, 
say  that  it  was  easier  to  procure  $2,000,000  at  the  outset 
than  to  secure  $200,000  after  $1,000,000  had  been  represented 
as  all  that  would  be  necessary.  If  the  method  of  assessable 
stock  is  adopted,  stock  can  be  issued  to  the  amount  of  $1,000,- 
000,  with  an  understanding,  which  is  not,  of  course,  a  part 
of  the  subscription  contract,  that  only  $500,000  need  be  called. 
If,  then,  it  is  found  necessary  to  call  $250,000  more,  this 
can  be  secured  without  difficulty  since  the  stockholders  will 
not  wish  to  see  their  original  investment  forfeited  by  a  sale 
of  their  stock  by  the  company  to  pay  up  the  assessment. 

Assessable  stock  can  also  be  issued  to  capitalize  future 
profits  when  it  is  not  deemed  prudent  to  pay  too  large  a 
dividend.  If  a  street  railway  consolidation  requires  $15,000,- 
000  cash,  and  if  public  sentiment  will  not  tolerate  more  than 
six  per  cent  in  dividends  on  the  stock  of  a  public  service 
corporation,  it  may  be  possible  to  capitalize  the  new  enter- 
prise at  $45,000,000,  calling  one  third  of  the  amount  and 
allowing  the  balance  to  stand  as  a  liability  of  the  stockholder. 
If  the  earnings  of  the  company  warrant,  the  six  per  cent 
dividend  can  be  paid  on  $45,000,000  which  in  reality  is  eight- 
een per  cent  on  the  amount  paid  in.  While  this  method  has 
been  occasionally  employed,  however,  it  cannot  be  considered 
as  a  general  practice  among  public  corporations. 


METHODS    OF   PAYING   FOE   STOCK         105 

Assessable  stock  is  not  a  popular  form  of  security.  The 
unpaid  portion  of  such  stock  operates  to  depress  its  value. 
Investors  can  never  be  certain  when  the  directors  will  call 
assessments.  When  a  call  is  made,  those  holders  who  are 
unable  to  respond  must  throw  a  portion  of  their  stock  on 
the  market  to  obtain  sufficient  funds  to  pay  the  assessments 
on  the  remainder.  These  sales  not  only  make  the  value  of 
partly  paid  shares  irregular,  but  open  the  way  to  unscru- 
pulous directors  to  enrich  themselves  at  the  expense  of  the 
stockholders  by  buying  the  stock  on  the  decline  and  selling 
at  the  advance  which,  since  the  real  value  of  the  stock  has 
been  increased  by  the  assessment,  is  likely  to  follow  its  pay- 
ment. 

The  investor  has  a  rooted  objection  to  purchasing,  assess- 
able stock  because  of  the  uncertainty  as  to  the  amount  he  will 
be  called  upon  to  pay,  and  because  of  a  well  grounded  dis- 
trust of  the  danger  of  manipulation  by  directors  who  are  in 
a  position  to  control  the  times  and  amounts  of  the  calls. 
When  stock,  therefore,  is  to  be  sold  to  investors,  it  is  necessary 
to  make  it  full  paid.  This  can  be  done,  either  by  paying 
for  the  stock  in  cash,  or  by  issuing  it  in  exchange  for  prop- 
erty or  services.  The  only  way  in  which  promoters  can  make 
a  profit  on  stock  which  has  been  paid  up  in  cash  is  to  sell  this 
stock  at  a  premium.  Since  we  are  dealing  here,  it  will  be 
remembered,  with  new  enterprises,  whose  earning  power  is 
yet  to  be  demonstrated,  and  which  must  offer  inducements 
to  investors  to  secure  funds,  this  method  is  impossible,  at 
least  in  the  United  States.  In  Germany,  where  the  law  for- 
bids the  stock  of  any  new  enterprise  to  be  listed  for  sale 
until  the  company  has  been  in  operation  for  a  year,  and 
where  the  amount  of  capital  is  strictly  limited,  it  frequently 
happens  that  a  large  premium  can  be  secured,  and  a  consider- 
able profit  realized.  In  Great  Britain,  where  founder's  shares, 
entitling  their  holder  to  a  disproportionately  large  share  of 
profits  are  used  to  compensate  promoters,  these  shares  fre- 
quently sell  at  a  high  premium.  In  the  United  States,  how- 
ever, where  the  law  allows  listing  at  once,  and  founder's 


106  COKPOKATION   FINANCE 

shares  are  not  as  yet  employed,  the  risks  of  new  enterprises 
are  so  great  and  the  demand  for  banke^-'s  capital  so  heavy, 
that  very  little  time  is  allowed  to  elapse  between  the  com- 
pletion of  the  construction  or  consolidation  and  the  sale  of 
its  securities.  This  unwillingness  of  the  investor  to  buy  se- 
curities of  new  enterprises,  except  on  very  favorable  terms, 
extends  to  its  bonds.  To  sell  bonds,  it  is  sometimes  necessary 
to  give  a  bonus  in  stock  from  which  the  corporation  will  re- 
ceive no  cash  whatever.  This  stock,  to  be  attractive  to  the 
investor,  must  be  full  paid. 

From  these  several  considerations,  it  is  evident  that  some 
method  must  be  devised  of  making  stock  full  paid,  which  will 
not  require  the  payment  of  its  par  value  in  cash.  This 
method  is  the  issuing  of  stock  for  property  or  services.  The 
laws  of  every  State  permit  the  directors  of  corporations  to 
purchase  such  property  as  it  may  need  by  issuing  its  stock. 
Corporations  are  also  allowed  to  make  contracts  for  construc- 
tion work,  payment  for  which  is  to  be  made  in  bonds  and 
stocks.  One  of  the  most  liberal  statutes  permitting  the  pur- 
chase of  property  with  stock  is  that  of  New  Jersey.  Section 
49  of  the  General  Corporation  Act  of  New  Jersey  is  as 
follows : 

Any  corporation  formed  under  this  act  may  pur- 
chase mines,  manufactories,  or  other  property  neces- 
sary for  its  business,  or  the  stock  of  any  company  or 
companies  owning,  mining,  manufacturing,  or  pro- 
ducing materials,  or  other  property  necessary  for  its 
business,  and  issue  stock  to  the  amount  of  the  value 
thereof  in  payment  therefor,  and  the  stock  so  issued 
shall  be  full  paid  stock  and  not  liable  to  any  further 
call,  neither  shall  the  holder  thereof  be  liable  for  any 
further  payment  under  any  of  the  provisions  of  this 
act;  and  in  the  absence  of  actual  fraud  in  the  transac- 
tion, the  judgment  of  the  directors  as  to  the  value  of 
the  property  purchased  shall  be  conclusive,  and  in  all 
statements  and  reports  of  the  corporation  to  be  pub- 
lished or  filed  this  stock  shall  not  be  stated  or  reported 
as  being  issued  for  cash  paid  to  the  corporation,  but 
shall  be  reported  in  this  respect  according  to  the  fact. 


METHODS    OF   PAYING   FOR   STOCK         107 

The  New  Jersey  Corporation  Law  also  authorizes  the  is- 
suance of  stock  and  bonds  for  services  rendered  in  the  follow- 
ing section : 

Corporations  having  for  their  object  the  building, 
constructing,  or  repairing  of  railroads,  water,  gas,  or 
electric  works,  tunnels,  bridges,  viaducts,  canals,  hotels, 
wharves,  piers,  or  any  like  works  of  internal  improve- 
ment or  public  use  or  utility,  may  subscribe  for,  take, 
pay  for,  hold,  use,  and  dispose  of  stock  or  bonds  in  any 
corporation  formed  for  the  purpose  of  constructing, 
maintaining,  and  operating  any  such  public  works, 
and  the  directors  of  any  such  corporation  formed  for 
the  purpose  of  constructing,  maintaining,  and  oper- 
ating any  public  work  of  the  description  aforesaid, 
may  accept  in  payment  of  any  such  subscription,  or 
purchase,  real  or  personal  property,  necessary  for  the 
purpose  of  such  corporation,  or  work,  labor,  and  serv- 
ices performed  or  materials  furnished  to  or  for  such 
corporations  to  the  amount  of  the  value  thereof,  and 
from  time  to  time  issue  upon  any  such  subscription 
or  purchase,  in  such  installments  or  proportions  as 
such  directors  may  agree  upon,  full  paid  stock  in  full 
or  partial  performance  of  the  whole  or  any  part  of 
such  subscription  or  purchase,  and  the  stock  so  issued 
shall  be  full  paid  and  not  liable  to  any  further  call. 

The  method  described  in  this  section  is  that  usually  fol- 
lowed for  making  stock  full  paid.  After  the  corporation  is 
organized,  the  first  meeting  of  the  stockholders  held,  and  the 
directors  elected,  a  proposition  is  made  to  the  directors  to 
sell  to  the  corporation  certain  property — patents,  mining 
property,  factory  property,  railroads  or  stocks  and  bonds,  for 
all  or  part  of  the  securities  of  the  new  corporation.  The 
only  limit  in  most  States  to  the  amount  of  bonds  which  may 
be  issued  under  these  circumstances  is  the  conclusion  of  the 
directors  as  to  their  need  of  capital  and  their  ability  to  sell 
these  bonds.  The  law  does,  however,  limit  the  stock  "  to  the 
judgment  of  the  directors  as  to  the  value  of  the  property 
purchased."    As  long  as  this  judgment  is  an  honest  judgment. 


108  COKPOKATION   FINANCE 

and  there  is  no  suspicion  of  fraud  in  the  transaction,  it  will 
be  held  to  be  final,  and  cannot  be  questioned  in  subsequent 
proceedings  against  the  corporation. 

In  fixing  a  value  upon  the  property  purchased,  or  upon 
work  which  is  to  be  done  for  the  company,  the  directors  are 
not  to  be  limited  to  the  sum  for  which  the  property  would 
sell  for  cash,  or  to  the  amount  for  which  the  services  could 
be  purchased  for  cash.  The  payments  are  not  made  in  cash, 
but  in  evidences  of  debt,  and  in  certificates  of  rights  to  partic- 
ipate in  profits.  The  ability  of  the  corporation  to  pay  inter- 
est on  these  bonds  is  yet  to  be  demonstrated.  The  profits, 
in  which  the  holders  of  these  shares  of  stock  are  to  partic- 
ipate, are  yet  to  be  realized.  Anyone  who  transfers  property 
or  contracts  to  perform  services  for  a  company,  in  exchange 
for  securities,  has  a  right  to  charge  a  much  higher  price  than 
if  he  is  to  receive  cash  for  his  property  or  services.  The 
corporation,  for  its  part,  is  warranted  in  paying  a  much  higher 
price  for  property  or  services  expressed  in  terms  of  securities. 
When  the  vendors  or  contractors  will  agree  to  accept,  instead 
of  cash,  which  the  corporation  might  have  great  difficulty  in 
securing,  its  bonds  and  stock,  making  it  unnecessary  for  the 
corporation  itself  to  raise  more  than  a  moderate  amount  of 
money  for  working  capital,  they  are  entitled  to  liberal  terms. 
The  valuation  placed  upon  property  or  services  by  directors 
is  generally  accepted  by  the  courts.  They  will  not  question 
the  amount  of  stock  to  be  issued,  either  in  behalf  of  dis- 
gruntled stockholders,  or  of  creditors,  unless  it  appears  that 
the  transaction  is  tainted  with  fraud. 

Practically  speaking,  the  only  risk  attaching  to  the  over- 
valuation of  property,  when  purchased  with  stock,  arises  in 
case  of  the  subsequent  bankruptcy  of  the  company  issuing  the 
stock.  If  the  creditors  of  the  corporation  can  prove  that 
stock  was  fraudulently  issued,  and  if  they  can  find  this  stock 
in  the  possession  of  the  original  incorporators,  or  those  for 
whom  these  incorporators  were  acting,  it  has  been  established 
that  the  receiver  of  the  corporation,  acting  for  the  creditors, 
can  recover  from  the  subscribers  such  part  of  the  difference 


METHODS    OF   PAYING   TOR   STOCK         109 

between  the  par  value  of  the  stock  which  they  received  for 
their  property,  and  what  the  court  will  regard  as  a  fair 
value  for  the  property  measured  in  stock,  as  will  make  up 
the  difference  between  the  realizable  value  of  the  company's 
assets,  and  the  amount  of  the  creditor's  claims.  Under  these 
circumstances,  the  so-called  full  paid  stock  of  the  company, 
if  it  has  been  issued  to  an  excessive  amount,  is  held  to  be 
assessable  stock,  the  corporation  not  having  received  full 
value,  and  those  who  have  received  the  stock,  if  it  is  found 
in  their  hands,  are  liable  for  the  difference  between  the  sell- 
ing price  and  the  par  value  of  the  stock. 

The  theory  of  the  law  under  which  liability  attaches,  is 
that  the  capital  of  the  corporation  takes  the  place  of  the  in- 
dividual liability  of  the  partners,  so  far  as  the  creditors  are 
concerned,  and  that  creditors  have  the  right  to  assume  that 
the  capital  of  the  company  has  been  paid  up  in  full,  either 
with  cash,  or  with  property  and  services  taken  at  a  fair  value. 
When,  therefore,  the  company  fails,  and  the  creditors  are 
able  to  prove  that  the  stock  was  issued  for  property  and 
services  at  fictitious  and  excessive  values,  it  is  held  that  they 
can  recover  through  the  corporation  from  the  original  sub- 
scribers if  they  find  the  stock  in  their  hands.  This  liability 
does  not  attach  to  innocent  holders  for  value,  and  it  is  a 
question  whether  the  original  subscribers  may  not  divest 
themselves  of  all  liability  by  transferring  their  stock  on  the 
books  of  the  company. 

The  purchase  of  property  with  stock  of  a  corporation 
directly  from  the  owner  presents  no  difficulty.  When  services 
are  to  be  performed  for  the  company,  however,  in  order  to 
make  the  stock  full  paid,  it  is  necessary  to  interpose  between 
the  final  purchaser  of  the  stock  and  the  corporation  an 
agency  known  as  the  Construction  Company,  which  exchanges 
its  contract  for  services  to  be  performed  for  the  stock  and 
bonds  of  the  company  in  whose  interest  the  work  is  to  be 
done.  A  construction  company  is  not  often  what  its  name 
implies.  As  a  rule,  it  does  not  expect  to  carry  on  any  work 
of  construction.    It  has  no  force  of  engineers  at  its  disposal. 


110  COEPORATION   FINANCE 

It  expects  to  let  the  contracts  connected  with  the  work  to 
others.  It  is  merely  a  device  to  make  stock  full  paid  so  that 
it  can  be  sold  to  the  investor  without  any  liability  attaching. 
A  typical  construction  company  transaction  is  outlined  in 
the  following: 

OFFEEING    OF    BONDS    AND    STOCK 

OF 

THE  DENVER  NORTHWESTERN   &  PACIFIC 
RAILWAY  COMPANY 

Payments  to  be  Made  in  Instalments  or  at  Once  at 
Subscriber's  Option. 

Denver,  Col.,  October  21,  1902. 

The  Colorado-Utah  Construction  Company  has  con- 
tracted with  the  Denver  Northwestern  &  Pacific  Rail- 
way Company  to  build  and  equip,  approximately,  500 
miles  of  its  railroad  between  Denver,  Col.,  and  Salt 
Lake  City,  Utah.  The  contract  provides  for  a  sub- 
stantial roadbed,  steel  rails  eighty  pounds  per  yard, 
and  a  modern  standard  passenger  and  freight  rolling 
stock  equipment.  Payments  under  this  contract  are 
to  be  made  in  the  bonds  and  stock  of  the  Railway 
Company  which  are  now  offered  for  subscription. 

Under  the  provisions  of  the  construction  contract, 
there  will  be  issued  by  the  Railway  Company  to  the 
Construction  Company  $40,000,  and  no  more,  of  the 
first  mortgage  four-per-cent  bonds  of  the  Railway 
Company  and  $20,000,  par  value,  of  its  full  paid  pre- 
k  ferred  stock  and  $20,000,  par  value,  of  its  full  paid 
common  stock  for  each  mile  of  main  track  of  railroad 
as  it  is  built,  equipped,  and  turned  over  to  the  Rail- 
way Company  for   operation. 

The  authorized  capital  stock  of  the  Railway  Com- 
pany is  $20,000,000,  of  which  $10,000,000  is  five-per- 
cent noncumulative  preferred  stock  and  $10,000,000  is 
common  stock. 

The  first  mortgage  of  the  Railway  Company  to  The 
Mercantile  Trust  Company,  of  New  York,  provides 
for  an  issue  of  not  exceeding  $22,500,000  of  Fifty- 


METHODS  OF  PAYING  FOE  STOCK    HI 

Year  Four-Per-Cent  Gold  Bonds,  of  which  issue  the 
balance  of  $2,500,000,  remaining  after  the  payments 
to  be  made  under  the  construction  contract  will  be 
held  in  reserve  by  the  Railway  Company. 

The  Colorado-Utah  Construction  Company  will  re- 
ceive, through  its  designated  depositaries,  applications 
for  subscriptions  in  $1,000,  and  multiples  of  $1,000, 
to  the  bonds  and  stock  of  the  Denver  Northwestern 
&  Pacific  Railway  Company  above  mentioned  until 
November  16,  1902,  after  which  no  further  applica- 
tions will  be  received. 

The  Colorado-Utah  Construction  Company  reserves 
the  right  to  scale  down  or  to  reject  any  and  all  appli- 
cations. 

The  terms  of  the  subscription  agreement,  which  is 
to  be  signed  by  the  parties  whose  applications  shall 
be  accepted  by  the  undersigned,  provide  that  payment 
shall  be  called  in  as  money  is  required  by  the  Con- 
struction Company  for  the  purpose  of  fulfilling  its 
contract  with  the  Railroad  Company,  but  that  in  no 
event  shall  the  subscribers  be  required  to  pay  more 
than  ten  per  cent  of  their  subscriptions  in  any  one 
month;  but  that  each  subscriber  shall  have  the  option 
to  pay  the  whole  amount  subscribed  at  once.  Each 
subscriber  will  receive,  as  provided  in  the  subscription 
agreement,  for  each  $950  paid: 

$1,000    four-per-cent    fifty-year    First    Mortgage 

Gold  Bonds  of  the  Railway  Company, 
$250  par  value  of  the  Non-Cumulative  Preferred 

Stock,  and 
$250  par  value  of  the  Common  Stock  of  the  Rail- 
way Company. 
Until  the  bonds  and  stock  of  the  Railway  Company 
are  engraved,  executed,  and  received  by  the  Construc- 
tion Company  under  the  terms  of  its  contract  with  the 
Railway  Company,  the  Construction  Company  will  is- 
sue to  the  subscribers,  as  any  payment  is  made  upon 
their  subscriptions,  its  receipts  providing  for  the  pay- 
ment of  interest  from  the  date  of  such  payment  at  the 
rate  of  four  per  cent  per  annum  until  the  bonds  and 
stock   subscribed   for   are   ready   for   delivery   to   the 
subscribers,  subject  to  adjustment  to  be  made  as  to 
any  interest  then  accrued  upon  such  bonds. 


112  CORPOEATION   FINANCE 

The  one  half  of  the  common  and  preferred  stock  of 
the  Railway  Company  not  offered  for  subscription  will 
be  owned  by  the  Construction  Company. 

The  above  offer  is  made  upon  the  terms  above  stated, 
subject  to  advance  or  withdrawal  without  notice,  and 
the  undersigned  recommends  the  bonds  and  stock  of 
the  Denver  Northwestern  &  Pacific  Railway  Company 
as  a  safe  and  profitable  investment. 

THE  COLORADO-UTAH  CONSTRUCTION 
COMPANY, 

By  Sylvester  T.  Smith,  President. 

The  foregoing  shows  very  clearly  the  service  which  the 
construction  company  performs.  The  Denver  Northwestern 
&  Pacific  Railway  property,  at  the  time  this  offer  was  made, 
was  not  yet  built.  The  public  was  expected  to  furnish  a 
large  part  of  the  funds  necessary  for  the  work.  Since  the 
enterprise  was  not  yet  in  being,  it  was  necessary  to  offer 
special  inducements  to  the  subscribers  to  the  bonds  in  the 
shape  of  bonus  in  stock.  This  stock  bonus  could  not  be  legally 
offered  by  the  railway  company.  The  construction  company 
was  therefore  employed  to  contract  with  the  railroad  com- 
pany to  build  its  line  in  return  for  securities.  These  secur- 
ities the  construction  company  forthwith  offered  to  the  pub- 
lic on  the  terms  set  forth  in  the  advertisement. 

The  above  method  is  not  often  employed.  As  a  general 
thing  bankers  profoundly  dislike  to  handle  any  other  securities 
than  those  issued  by  going  concerns.  It  is  usually  necessary, 
therefore,  for  a  considerable  amount  of  capital  to  be  raised  by 
the  construction  company,  with  which  it  margins  loans  made 
with  financial  institutions  on  the  security  of  the  stock  and 
bonds  which  it  receives  from  the  railway  company  as  the  work 
progresses.  The  following  is  a  detailed  description  of  a 
typical  operation  of  this  character: 

A  construction  company  is  organized  for  the  purpose  of 
building  a  line  of  railroad.    The  shares  of  the  construction 


METHODS  OF  PAYING  FOR  STOCK    US 

company  are  offered  for  subscription  to  obtain  working  cap- 
ital. Simultaneously  with  the  organization  of  the  construc- 
tion company,  a  railroad  company  is  incorporated.  An  agree- 
ment is  now  made  between  the  railroad  company  and  the 
construction  company  for  the  building  of  a  railroad,  and  for 
supplying  a  certain  amount  of  equipment  for  its  operation 
after  completion.  The  construction  company  agrees  to  secure 
the  necessary  rights  of  way,  and  to  construct  or  procure  for 
the  railroad  company,  upon  such  routes  as  it  may  select  for 
the  purpose,  a  certain  line  of  railroad.  It  is  stipulated  that  the 
work  to  be  performed  by  the  construction  company  shall 
be  in  accordance  with  standard  specifications,  and  under  the 
supervision  and  control  of  the  chief  engineer  of  the  railroad 
company.  The  track  shall  be  laid  with  first  quality  steel  rail, 
and  adequate  siding  facilities  provided  for  a  certain  stipulated 
sum.  Mileage,  depots,  water  stations,  section  houses  and  all 
other  structures  necessary  for  the  proper  handling  of  the 
business  shall  also  be  provided  for  at  such  points  as  the 
railroad  company  may  designate.  Telegraph  lines  shall  be 
constructed,  and  the  equipment  shall  be  of  such  a  character 
and  capacity  as  shall  be  designated  by  the  railroad  company. 
All  the  contracts  for  the  grading,  rails,  equipment,  and  all 
other  necessary  work  for  the  completion  of  the  railroad,  will 
be  let  by  the  construction  company. 

For  the  service  performed  in  constructing  the  railroad 
and  furnishing  a  certain  amount  of  equipment,  the  railroad 
company  agrees  to  deliver  to  the  construction  company  its 
full  authorized  capital  stock  at  a  certain  rate  per  mile  of 
railroad  constructed,  and  also  bonds  for  each  mile  so  con- 
structed. The  bonds  issued  shall  be  a  first  lien  on  the 
property,  and  before  any  shall  be  delivered  by  the  rail- 
road company  to  the  construction  company,  the  trustee  un- 
der the  mortgage  shall  be  furnished  with  a  certificate  certi- 
fying to  the  completed  mileage  by  the  chief  engineer  of  the 
railroad  company.  The  construction  company,  upon  the  com- 
pletion of  its  contract,  becomes  the  owner  of  all  the  stock 
and  bonds  of  the  railroad  company,  except  that  stock  which 


114  CORPOKATION   FINANCE 

was  subscribed  for  at  the  time  of  the  incorporation  of  the 
railroad  company,  and  that  necessary  for  the  qualification  of 
the  directors. 

"  A  construction  company  is  formed  with  a  capital  of 
$2,500,000.  Out  of  this  capital,  it  purchased  mining  interests 
which  cost  $500,000.  In  order  to  develop  this  operation,  a 
railroad  company  is  formed,  and  on  the  strength  of  the  balance 
of  the  capital  of  the  construction  company,  contracts  are  let 
and  work  begins.  The  mileage  to  be  constructed  is  200 
miles,  on  which  stock  at  the  rate  of  $16,500  per  mile,  and 
bonds  at  the  same  rate  can  be  issued.  Each  mile  of  railroad 
constructed  and  with  the  equipment  furnished,  costs  the 
construction  company  $18,000  per  mile.  On  a  mileage  of 
200  miles,  the  cost  would  be,  approximately,  $3,600,000. 

"  Under  the  terms  of  the  agreement  of  the  construction 
company  with  the  railroad  company,  as  the  work  progresses  in 
sections  of  so  many  miles,  the  construction  company  would  be 
entitled  to  bonds  at  $16,500  for  each  mile  so  constructed  upon 
delivery  of  the  certificates  of  the  chief  engineer  of  the  rail- 
road company  certifying  to  such  completed  mileage,  to  the 
trustee  under  the  mortgage, 

"After  paying  for  its  coal  estate,  the  construction  com- 
pany's available  capital  would  be  $2,000,000.  Upon  the  basis 
of  a  cost  of  $18,000  per  mile,  with  this  capital,  it  can  con- 
struct approximately  110  hailes,  under  w'hich  it  would  be 
entitled  to  receive  bonds  to  the  amount  of  $1,815,000.  This 
would  use  all  the  available  funds  of  the  construction  company. 
With  the  bonds  thus  received  (which  would  be  in  the  form 
of  temporary  certificates)  it  would  seek  loans  from  financial 
sources,  pledging  these  certificates  as  collateral,  on  the  basis 
of  sixty  per  cent  of  their  face  value.  Assuming  that  the 
loan  can  be  made  with  this  collateral  on  this  margin,  the  con- 
struction company  would  obtain  funds  for  the  further  con- 
struction to  the  extent  of  $1,089,000,  which  would  complete 
an  additional  sixty  miles,  upon  completion  of  which  the  con- 
struction company  would  be  entitled  to  receive  bonds  at  the 
rate  of  $16,500  per  mile,  or  $990,000  of  bonds.    To  complete 


METHODS    OF   PAYING   FOR   STOCK  115 

the  remaining  thirty  miles  under  the  contract,  the  construc- 
tion company  would  need  an  additional  loan  of  $540,000, 
and  if  the  same  method  of  borrowing  on  the  pledged  col- 
lateral is  pursued,  it  would  require  $900,000  of  the  $990,000 
bonds  received  for  the  former  sixty  miles  completed,  which 
would  leave  in  the  hands  of  the  construction  company  $90,000 
of  bonds,  plus  those  issued  for  the  last  thirty  miles  ($495,- 
000)  or  a  total  of  $585,000  of  bonds  with  all  the  capital 
stock,  amounting  to  $3,300,000,  and  the  coal  estate  costing 
$500,000,  as  assets,  and  with  liabilities  of  loans  to  the  amount 
of  $1,629,000  and  capital  stock  of  $2,500,000. 

"  The  property  of  the  railroad  is  now  put  into  operation. 
The  receipts  and  expenses  are  such  that  its  earning  power  % 
will  be  sufficient  to  meet  the  interest  on  the  bonds,  which 
will  tend  to  increase  their  value.  A  syndicate  is  now  formed 
to  take  the  bonds  at  ninety.  The  $2,715,000  of  bonds  held 
as  collateral  would  be  sold,  realizing  in  cash  $2,443,500. 
From  this  sum,  the  loans  amounting  to  $1,629,000  with  in- 
terest would  be  paid  off,  realizing  approximately  $800,000  in 
cash.  The  $585,000  bonds  among  the  assets  of  the  construc- 
tion company  would  also  probably  be  sold  at  ninety,  realizing 
in  cash  $526,500  which,  with  the  $800,000  remaining  from 
the  loans,  would  furnish  cash  to  the  amount  of  $1,326,500. 
With  this  cash  the  construction  company's  capital  stock, 
amounting  to  $2,500,000,  could  be  proportionately  paid  off, 
thus  reducing  it  to  $1,173,500  with  the  $3,300,000  capital 
stock  of  the  railroad  company  and  the  coal  estate  of  $500,000 
as  remaining  assets. 

"  In  order  to  wind  up  the  affairs  of  the  company,  and  to 
distribute  the  stock  of  the  railroad  company  to  the  construc- 
tion company  stockholders,  it  may  be  estimated  that  the  stock 
is  worth  $25  per  share  (par  value  $50).  For  the  66,000 
shares,  $1,650,000  could  be  realized,  which  would  be  dis- 
tributed to  the  stockholders  out  of  the  capital  stock  of  the 
construction  company,  amounting  to  $1,173,500,  leaving  a 
credit  balance  of  $476,500,  with  the  coal  estate.  It  has  been 
assumed  that  all  the  securities  would  be  sold  for  cash.    The 


116  CORPOKATION   FINANCE 

various  securities  could  be  distributed  among  the  stockholders 
of  the  construction  company.  The  stockholders  might  also 
become  members  of  the  underwriting  syndicate  to  take  the 
bonds  at  ninety."  ^ 

One  more  problem  arises  in  connection  with  the  issuing 
of  stock  for  property  or  services.  Every  new  enterprise  needs 
working  capital,  and  the  financial  plan  must  provide  for  this. 
A  portion  of  the  proceeds  of  the  securities  of  the  new  com- 
pany must  be  put  into  the  treasury  to  serve  the  current  needs 
of  the  corporation.  The  stock  of  the  new  company  cannot 
be  sold  at  par.  It  must  either  be  sold  at  a  discount,  or  given 
away  as  a  bonus  with  bonds  sold.  The  latter  method  is  gen- 
erally forbidden  the  corporation  by  law.  The  stock  can  be 
made  full  paid  by  transferring  it  for  property  or  services, 
and  then  can  come  into  possession  of  the  corporation  by  gift. 
The  company  can  sell  this  stock  or  give  it  as  a  bonus  with 
the  sale  of  bonds  as  it  sees  fit.  The  ordinary  method  of 
accomplishing  this  result  is  for  the  vendors  of  property,  or 
the  construction  company,  after  the  stock  has  been  made  full 
paid,  to  donate  to  the  company  a  certain  portion  of  what  they 
have  received,  to  be  placed  in  the  treasury  and  sold  to  provide 
working  capital. 

It  may  be  argued  for  the  construction  company  that  with- 
out this  agency  whose  subscribed  capital  guarantees  the  loans 
made  on  the  security  of  bonds,  enterprises  would  have  great 
difficulty  in  raising  money  for  construction.  Investors  are 
wary  of  new  concerns  which  are  not  on  a  going  basis.  Invest- 
ment bankers  usually  demand  a  showing  of  earnings  before 
risking  any  money  in  such  securities.  The  construction  com- 
pany, in  return  for  the  opportunity  of  large  profit  which  its 
dealings  with  the  railroad  company  presents,  is  willing  to 
take  risks  with  new  enterprises,  and  to  cooperate  with  financial 
institutions  in  furnishing  money  for  construction,  on  the 
security  of  the  bonds  of  the  new  company. 

^  This  account  of  the  operations  of  a  construction  company  was  ob- 
tained from  a  confidential  source,  on  the  promise  that  no  names  were 
to  be  mentioned. 


METHODS    OF  PAYING   FOR   STOCK         117 

A  potent  reason  for  the  use  of  the  construction  company, 
aside  from  the  evident  advantages  to  the  corporation  which 
have  been  enumerated,  is  the  fact  that  this  is  the  only  way 
in  which  the  promoters  of  an  enterprise  which  does  not  re- 
quire the  purchase  of  property,  but,  instead,  involves  the 
building  of  a  trolley  line  or  railroad,  to  bring  into  existence 
property  which  did  not  exist  before,  can  make  any  money  for 
themselves  out  of  the  scheme.  Even  if  the  law  permits  the 
railroad  company  to  sell  its  stock  as  a  bonus  with  bonds, 
and  supposing  a  railroad  company  sells  these  securities  direct 
and  the  money  is  placed  in  its  treasury,  these  funds  must  be 
spent  for  the  benefit  of  the  corporation.  There  is  no  way 
in  which  the  promoters  can  make  any  profit  from  them  except 
by  subscribing  to  the  stock  and  holding  it  for  an  indefinite 
period  until  it  shows  some  value.  By  utilizing  the  construc- 
tion company,  however,  they  can  make  a  contract  with  the 
railroad  company,  which  will  involve  the  payment  to  them 
of  a  sufficiently  large  amount  of  securities  to  reimburse  their 
expenses,  and,  at  the  same  time,  give  them  an  immediate 
profit  in  case  their  calculations  have  been  wisely  made. 

The  opportunities  for  making  money  out  of  construction 
companies  at  the  expense  of  the  corporation  are  very  great. 
This  necessary  and  useful  financial  agency  has  been  some- 
times abused  by  certain  officials  of  established  companies  in 
high  credit  which  did  not  need  the  assistance  of  the  construc- 
tion company  to  secure  funds.  Construction  companies  have 
also,  in  some  instances,  been  organized  by  those  interested  in 
these  companies  to  make  for  themselves  large  profits  by  bar- 
gaining with  the  corporation,  whose  interest  they  were  sup- 
posed to  safeguard,  to  do  construction  work  and  take  pajrment 
at  exorbitant  figures  in  securities  which,  as  they  well  knew, 
would  have  an  immediate  sale. 


CHAPTER    X 
THE  SALE  OF  SECURITIES 

We  have  now  reached,  in  the  development  of  our  corpora- 
tion, the  time  when  it  is  necessary  to  arrange  for  its  perma- 
nent financing.  Up  to  this  point,  the  money  which  has  been 
put  into  the  enterprise  has  been  advanced  by  members  of  the 
promoting  syndicate.  These  advances  are  intended  to  be 
temporary.  Both  the  members  of  the  syndicate  and  the  banks 
from  which  they  have  borrowed  expect  to  be  repaid  when  the 
securities  are  finally  sold.  Although  the  consti*uction  period 
may  be  prolonged  for  several  years,  either  because  of  unfore- 
seen difficulties,  or  because  it  is  deemed  essential  that  the 
enterprise  should  make  a  fair  showing  of  earnings  before  its 
securities  are  offered  for  sale,  the  promoters  wish  to  make  this 
period  of  development  as  brief  as  possible.  As  soon  as  the 
company  is  in  a  position  to  make  an  attractive  offer  of  stocks 
or  bonds,  the  securities  are  sold. 

There  are  two  methods  of  selling  securities;  either  to  the 
public  direct  or  to  investment  bankers.  The  security  business 
is  organized  along  lines  generally  similar  to  the  business  of 
producing  and  selling  commodities.  The  corporation  cor- 
responds to  the  manufacturer,  the  investor  to  the  consumer. 
Between  the  manufacturer  and  the  consumer,  stands  the  dis- 
tributer. The  wholesaler,  in  the  field  of  commodities,  and 
the  banker,  in  the  field  of  securities,  occupy  similar  positions. 
The  business  of  the  private  banker  has  assumed  great  im- 
portance in  recent  years.  At  one  time  it  was  thought  that 
the  function  of  distributing  securities  to  the  public  might  be 
taken  over  by  the  commercial  banker  who  would  buy  from 
118 


THE   SALE   OF   SECURITIES  119 

the  corporation  and  sell  to  his  own  depositors.  A  number  of 
the  larger  banks  and  trust  companies  have  gone  so  far  as  to 
establish  bond  departments.  But  while  there  is  a  certain 
amount  sold  by  commercial  banks  to  depositors,  for  the  most 
part  through  their  bond  departments,  as  a  rule  banks  dispose 
of  such  bonds  as  they  may  purchase,  in  the  general  investment 
market,  making  no  special  effort  to  interest  their  depositors, 
on  whose  funds  they  can  make  a  larger  profit  by  lending 
them  in  the  ordinary  course  than  by  using  them  in  the  pur- 
chase of  bonds.  It  is  now  admitted  that  the  bond  business, 
as  a  branch  of  mercantile  industry,  does  not  belong  to  the 
commercial  bank,  and  it  is  properly  left  to  a  special  kind 
of  financial  institution. 

The  investment  banker  on  his  part,  however,  may  advan- 
tageously carry  on  certain  departments  of  the  business  of  the 
commercial  bank.  The  investment  banker  offers  investment 
securities  suitable  to  the  needs  of  various  classes  of  investors, 
furnishes  to  investors  free  of  charge  accurate  information  on 
securities,  receives  accounts  subject  to  check,  and  allows  inter- 
est on  daily  balances,  collects  and  remits  dividends  and  inter- 
est; negotiates  collateral  loans  for  various  classes  of  borrow- 
ers, executes  orders  for  the  purchase,  sale,  or  exchange  of 
securities  on  the  stock  exchanges;  and,  in  some  cases,  carries 
on  the  business  of  foreign  exchange.  The  investment  business 
is,  however,  the  primary  function  of  the  private  banker.  To 
this  all  his  other  activities  are  subordinated. 

The  private  banker  organizes  his  business  on  the  lines  of 
a  jobbing  house.  He  has  a  large  number  of  present,  prospec- 
tive or  potential  customers  on  his  list  sometimes  running  into 
the  thousands.  He  circularizes  these  customers  at  intervals 
with  letters  and  circulars,  follows  up  all  inquiries  with  at- 
tractive prospectuses,  and  also  brings  the  merits  of  his  wares 
to  the  attention  of  the  buyer  by  means  of  public  advertise- 
ments. The  investment  banker  enjoys  special  advantages  for 
the  financing  of  his  business.  So  far  as  possible,  he  aims 
to  make  his  sales  and  purchases  coincide.  In  an  active  bond 
market,  it  is  not  unusual  that  a  large  issue  should  be  sold 


120  COEPOEATION   FINANCE 

before  the  banker  is  obliged  to  make  his  final  payment. 
When  a  stock  of  securities  is  to  be  carried,  however,  the 
investment  banker  employs  his  established  lines  of  credit  with 
banks  and  trust  companies,  pledging  the  securities  which  he 
is  holding  as  collateral  for  loans  on  various  margins  of  secur- 
ity, depending  on  the  quality  of  the  bond  or  stock  pledged 
and  the  conditions  of  the  loan  market.  By  the  liberal  em- 
ployment of  his  credit,  he  is  able  to  do  a  large  business  with 
a  comparatively  small  capital.  A  bond  house  with  a  capital 
of  $500,000  is  a  very  substantial  institution  of  its  class. 

These  investment  bankers  stand  ready  to  purchase  the 
securities  of  corporations  for  cash.  The  prices  which  they 
will  offer  are,  of  course,  below  those  which  they  expect  to 
receive,  the  margin  of  profit  demanded  depending  on  the 
salability  of  the  security,  and  the  salability  usually  depend- 
ing on  the  quality  determined  from  an  investment  standpoint. 
The  question  now  arises,  shall  the  promoters  of  the  new  cor- 
poration sell  the  securities  to  bankers,  or  shall  they  offer 
them  direct  to  the  public?  This  question  can  be  answered, 
without  serious  qualification,  and  with  few  exceptions,  in 
favor  of  dealing  with  the  banker. 

There  are  great  advantages  to  a  corporation  in  placing 
its  securities  with  investment  bankers.  The  cost  of  obtain- 
ing the  required  capital  is  definitely  determined  in  the  bank- 
er's contract.  If  the  bonds  are  to  be  sold  at  $85,  or  $90,  or 
$9 2 J,  the  exact  amount  of  money  which  will  be  received  from 
these  bonds  is  known.  The  money,  moreover,  will  be  paid 
at  a  definite  date,  so  that  the  syndicate  need  have  no  uncer- 
tainty about  recovering  their  advances  and  repaying  their 
loans.  The  cost  to  the  corporation  of  selling  securities  to 
bankers  is  also  much  less  than  if  sales  are  made  direct  to 
the  public,  and  the  certainty  of  return  is  far  greater.  The 
banker,  as  we  have  seen,  has  a  permanent  organization  and 
an  established  clientele  of  customers.  This  organization  is 
constantly  employed  in  marketing  securities.  Established 
banking  houses  of  good  reputation  have  a  large  number  of 
customers  who  will  buy  from  no  one  else.     They  can  count 


THE   SALE   OF   SECUKITIES  121 

on  a  certain  amount  of  money  from  these  customers  at  reg- 
ular intervals,  which  will  be  spent  on  the  securities  which 
they  offer.  They  are  also  able  to  make  a  market  for  new 
securities,  for  which  the  demand  may  be  weak  at  the  outset, 
by  exchanging  these  new  bonds  on  a  favorable  basis  for 
seasoned  bonds  of  long  standing,  which  its  regular  customers 
have  purchased  in  the  past,  and  for  which  a  ready  market 
exists.  With  a  large  number  of  satisfied  customers  with 
whom  the  banker  is  in  constant  touch,  new  issues  of  secur- 
ities can  be  quickly  sold  by  exchange,  when  direct  sale  would 
be  impossible.  Bankers,  moreover,  are  not  obliged  to  force 
a  market  for  the  securities  which  they  purchase.  They  can 
utilize  their  credit  to  carry  stocks  and  bonds  until  a  favor- 
able season  arrives  for  selling  them.  . 

A  corporation  engaged  in  the  mining  of  coal  or  the  opera- 
tion of  an  interurban  electric  railway  has  none  of  the  equip- 
ment for  selling  securities.  If  it  desires  to  sell  bonds  direct 
to  the  public,  it  .will  be  necessary  for  the  company  to  con- 
struct a  selling  machine  for  the  express  purpose,  and  since 
it  cannot  keep  this  organization  together  after  the  necessity 
out  of  which  it  originated  has  passed,  its  cost  will  be  excessive. 
It  must  rely  on  newspaper  advertising  to  discover  its  custom- 
ers, and  newspaper  advertising  is  an  expensive  method  of 
selling  securities.  The  corporation,  while  it  might  have  a 
good  credit  for  the  purposes  of  its  own  business,  would  have 
great  diflSculty  in  establishing  a  credit  with  which  to  finance 
its  venture  into  the  security  business.  The  same  banker 
might  look  with  favor  on  a  proposition  coming  from  an  in- 
vestment banker  to  lend  money  on  the  securities  of  a  cor- 
poration, which  that  investment  banker  had  purchased  for 
sale,  and  might  look  with  extreme  disfavor  upon  a  proposition 
to  lend  on  the  same  securities  offered  by  the  corporation 
direct. 

There  is  no  certainty,  when  the  securities  are  offered  direct 
to  the  corporation,  as  to  the  cost  of  selling.  The  usual  method 
will  be  to  turn  the  work  over  to  some  advertising  agency 
which  would  undertake,  without  any  guarantee  of  results,  to 


122  COEPOKATION   FINANCE 

sell  the  securities  on  the  basis  of  a  certain  percentage  of  the 
proceeds.  In  some  cases,  this  percentage  would  run  as  high 
as  forty  per  cent,  and  the  selling  campaign  might,  at  that, 
have  to  be  abandoned  before  half  of  the  securities  were  dis- 
posed of.  From  every  standpoint,  the  attempt  of  a  company 
to  market  its  securities  direct  will  be  likely  to  prove  unsatis- 
factory and  unsuccessful.  The  cost  will  be  excessive,  the 
results  uncertain,  and  the  risks  great. 

But  while  sale  to  a  banker  is  advantageous  to  the  com- 
pany, bankers  will  not  purchase  every  kind  of  security.  They 
sell  to  investors,  and  the  securities  which  they  offer  must  be 
such  as  will  appeal  to  their  customers.  We  may  distinguish 
between  investment  securities  and  speculative  securities.  Both 
the  investor  and, the  speculator  are  so  called  because  they 
buy  stock  or  bonds  of  companies  which  are  the  owners  of 
productive  properties.  By  means  of  the  corporation  which 
divides  its  stock  or  debt  into  shares  or  notes  of  $50,  $100,  or 
$1,000  each,  and  which  is  managed  by  officers  elected  by 
trustees  whom  the  stockholders  select,  an  individual  can  be- 
come a  part  owner,  or  a  part  creditor,  of  as  large  a  number 
of  corporations  as  his  capital  will  allow,  without  identifying 
himself  in  any  way  with  the  management  of  any  of  these 
corporations.  He  has  no  concern  in  their  affairs,  save  to 
receive  out  of  their  earnings  his  dividends  or  interest,  or  to 
increase  his  capital  by  selling  his  stocks  or  bonds  should  their 
price  be  advanced.  Broadly  speaking,  there  are  two  kinds 
of  enterprises,  and  two  kinds  of  securities  which  these  enter- 
prises may  issue:  Those  which  have  been  in  existence  a  suf- 
ficient time  to  enable  their  earning  power  to  be  conclusively 
demonstrated;  and  those  which  have  not  yet  demonstrated 
their  earning  power,  either  because  they  exist  only  on  paper, 
or  because  their  operations  have,  as  yet,  been  unsuccessful. 

Examples  of  investment  stocks  are  furnished  by  such  com- 
panies as  the  Pennsylvania  Railroad,  the  Chicago  and  North- 
western, the  Chicago,  Milwaukee  &  St.  Paul,  among  railroads ; 
the  Cambria  Steel  Company,  the  Standard  Oil  Company  and 
the  General  Electric  Company,  among  industrials;  the  Union 


THE   SALE   OF   SECURITIES  123 

Traction  Company  and  the  Chicago  City  Railway  Company, 
among  street  railways ;  the  Calumet  and  Heckla  among  mines. 
An  examination  of  these  stocks  shows  the  following  char- 
acteristics: Each  of  these  companies  operates  an  established 
business,  supplying  articles  or  service  for  which  there  is  a 
steady  demand,  and  where  the  processes  of  the  industry  are 
standardized  and  thoroughly  understood.  Each  one  of  these 
companies  is  efficiently  managed.  Their  costs  of  production 
are  low,  their  selling  methods  are  efficient,  and  their  financial 
management  conservative.  Each  one  of  these  corporations 
has  been  profitable  for  many  years.  In  good  times,  as  well 
as  in  periods  of  depression,  their  net  profits  have  been  far 
more  than  sufficient  to  pay  their  operating  expenses  and  their 
fixed  charges.  Each  one  of  these  companies  has  a  record  of 
dividend  payments.  The  directors  have  dealt  fairly  with  the 
stockholders  in  paying  to  them  such  part  of  the  profits  as 
could  be  safely  distributed.  Anyone  who  buys  the  stocks 
of  these  companies  knows  that  profits  will  be  earned,  and 
that  he  will  receive  as  large  a  part  of  these  profits  as  can 
be  prudently  paid  to  him. 

We  have  here  the  requisites  of  an  investment  security: 
an  established  business,  efficient  management,  assured  profits 
and  a  conservative  distribution  of  profits  to  stockholders. 
If  any  of  these  characteristics  are  absent  from  a  security,  it 
is  not  entitled  to  be  called  an  investment,  because  there  is 
no  guarantee  to  the  investor  that  the  income,  on  the  basis 
of  which  he  buys  the  stock  or  bond,  will  be  permanent. 

A  speculation  is  illustrated  by  the  stock  of  The  Consoli- 
dated Oil  Company.  This  company  controls  120  acres  of 
land  in  the  Coalinga  district  of  Southern  California,  touch- 
ing so-called  "proven  land,"  that  is  land  in  which  paying 
oil  wells  are  in  operation.  This  company  offers  a  portion  of 
its  capital  stock  for  sale  at  one  third  of  its  par  value.  "  With 
the  proceeds  it  is  proposed  to  drill  a  well  and  it  is  practically 
a  certainty  that  we  will  have  at  least  a  500  barrel  well  within 
a  few  months.  If  you  have  carefully  read  this  book  you  will 
understand  that  the  profits  from  this  one  well  should  drill 


124  COKPOEATION   FINANCE 

two  more  and  leave  some  money  over  for  dividends.  Then 
these  three  should  produce  enough  to  drill  six  more,  and, so 
on  up  to  about  twenty  wells,  which  the  company  should  have 
in  two  years.  These  twenty  wells,  remember,  will  be  drilled 
with  profits  after  the  first  one,  and  should  make  the  company 
over  $1,000,000  profits  per  year."  The  directors  and  pro- 
moters of  this  company  are  not  known  as  men  who  have  been 
successful  in  the  oil  business,  and  no  representations  of  their 
previous  experience  are  made  in  the  prospectus.  That  their 
means  are  limited,  is  shown  by  the  fact  that,  instead  of  tak- 
ing advantage  of  this  golden  opportunity  themselves,  they  are 
forced  to  appeal  to  the  public  to  supply  the  means  of  develop- 
ing their  proposition.  Here  are  all  the  elements  of  a  specu- 
lation, an  enterprise  which  may  or  may  not  be  successful. 
Oil  is  being  produced  in  California  at  a  profit.  The  property 
of  this  company,  if  its  representations  are  to  be  believed,  is 
near  the  oil  reservoir.  If  oil  is  discovered,  it  is  probable  that 
it  can  be  produced  at  a  profit.  So  much  can  be  said  in 
favor  of  the  proposition.  On  the  other  hand,  there  are  several 
unfavorable  considerations.  Oil  may  not  be  found,  or  if  it 
is  discovered,  the  flow  may  cease  after  a  short  time.  The 
company  may  not  be  able  to  store  or  transport  this  oil.  The 
officers,  even  though  honest,  having  had  no  previous  experi- 
ence, may  prove  incompetent.  They  may  involve  the  com- 
pany in  obligations  whose  maturity  may  destroy  the  value 
of  its  stock,  or  they  may  fritter  away  its  funds.  The  Con- 
solidated Oil  Company  is  an  illustration  of  a  type  of  specu- 
lation where  the  company  has  not  yet  come  into  existence, 
where  its  future  is  wholly  problematical. 

The  Allis- Chalmers  Company  was  incorporated  in  1901,  as 
a  consolidation  of  companies  manufacturing  heavy  engines, 
mining  and  other  machinery.  This  company  has  outstanding 
$19,820,000  of  common  stock,  $16,150,000  of  preferred  stock, 
and  $10,325,000  of  bonds.  On  the  preferred  stock  seven  per 
cent  was  paid  from  July,  1901  to  February,  1904.  Since 
that  time,  no  dividends  have  been  paid.  No  dividends  have 
been  paid  on  the  common  stock  from  the  beginning.    Here, 


THE   SALE   OF   SECURITIES  125 

the  separate  concerns  which  were  merged  into  this  company 
were  profitable,  and  tliey  have  continued  to  be  profitable. 
The  anticipated  increase  in  profits,  as  a  result  of  the  combi- 
nation, was  not,  however,  sufficient  to  pay  dividends  on  the 
stock,  which  represented  a  large  increase  over  the  combined 
stock  of  the  merged  companies.  The  Allis-Chalmers  Com- 
pany may  some  time  prove  to  be  an  investment,  but  the 
earnings  up  to  the  present  time  have  not  been  sufficient  to 
warrant  the  maintenance  of  dividends  on  its  preferred  stock, 
and  the  common  stock  is  apparently  a  long  way  off  from 
a  dividend.  Even  the  bonds  are  not  considered  to  be  espe- 
cially safe.  The  stock  of  the  Allis-Chalmers  Company  illus- 
trates a  type  of  security  in  which  the  business  has  not  been 
as  profitable  as  was  anticipated,  and  where  dividends  could 
not,  therefore,  be  maintained. 

The  stock  of  the  Westinghouse  Electric  &  Manufacturing 
Company  is  issued  by  a  company  which,  while  profitable, 
and  while  paying  dividends  for  many  years,  was  yet  so  badly 
managed  as  to  be  forced  into  bankruptcy.  The  stock  of  this 
company  cannot,  therefore,  be  considered  as  an  investment. 
Although  the  management  has  changed,  several  years  of  suc- 
cessful and  conservative  operation  must  elapse  before  the  com- 
pany is  completely  reinstated  in  the  confidence  of  the  investor, 
when  its  securities  will  be  fully  acceptable. 

The  Aiiialgamated  Copper  Company  and  the  American 
Smelting  &  Eefining  Company  are  corporations  which  have 
paid  out  the  greater  portion  of  their  earnings  to  their  stock- 
holders. In  times  of  prosperity,  these  stocks  sell  at  high 
values  because  of  this  policy  of  liberal  distribution.  During 
a  period  of  depression,  however,  dividend  payments  are  greatly 
reduced.  These  stocks  are,  therefore,  regarded  as  specula- 
tions. 

We  see  from  a  comparison  of  these  illustrations,  that  the 
characteristics  of  a  speculative  security  are  the  exact  opposites 
of  the  distinguishing  features  of  an  investment.  .  If  a  com- 
pany is  a  new  enterprise,  or  if  the  efficiency  of  its  manage- 
jiiont  is  doubtful,,  or  if  it  has  not  yet  come  into  a  stage  of 


126  COKPORATION   FINANCE 

profitable  operation,  or  if,  as  happens  in  rare  instances,  it 
has  made  profits  and  has  not  distributed  them  to  the  stock- 
holders, or  finally,  if  it  has  paid  out  too  large  a  percentage 
of  profits  so  that  it  has  been  obliged  to  suspend  dividends 
when  earnings  declined,  its  stock  must  be  regarded  as  specu- 
lative. 

Between  the  best  class  of  stock  investments,  of  which  the 
stock  of  the  Pennsylvania  Railroad  is  an  illustration,  and 
the  stock  of  The  Consolidated  Oil  Company  which  stands 
at  the  bottom  of  the  list,  there  are  degrees  of  difference, 
and  it  is  difficult  to  sharply  divide  the  sheep  from  the 
goats.  For  our  present  purpose,  however,  which  is  to  examine 
the  different  methods  of  selling  investment  and  speculative 
securities,  it  is  sufficient  to  characterize  as  investment  those 
enterprises  which  have  already  succeeded,  or  whose  success 
can  be  confidently  predicted  from  the  experiences  of  similar 
enterprises  operating  under  conditions  generally  identical,  as 
for  example  the  introduction  of  a  street  railway  in  a  town 
of  50,000  people,  and  to  distinguish  from  these,  as  speculative 
securities,  stocks  and  bonds  of  enterprises  whose  success  lies 
in  the  future.  The  distinguishing  characteristic  of  a  specu- 
lation is  the  fact  that  its  value  depends  upon  circumstances 
which  cannot  be  known  because  the  future  is  intended  to 
reveal  them.  An  investment  on  the  other  hand  contains  no 
"  if s  "  or  "  provideds  "  or  "  believes,"  its  value  is  founded 
upon  certainty.  The  value  of  a  speculative  security  is  built 
upon  the  unstable  foundations  of  probabilities  and  sup- 
positions. 

These  two  classes  of  securities  correspond  broadly  to  the 
characters  of  the  people  who  buy  them.  The  stocks  and 
bonds  of  established  companies,  where  success  is  certain,  are 
purchased  by  investors,  speculative  securities  by  speculators. 
The  investor  will  not  buy  a  security  whose  value  is  in  any 
way  doubtful.  He  demands  in  a  stock  or  bond,  before  any- 
thing else,  the  virtue  of  stable  value.  He  must  be  reasonably 
certain  that  his  principal  is  safe,  that  he  can,  at  any  time 
in  the  future,  disregarding  the  occasional  fluctuations  of  the 


THE   SALE   OF   SECUKITIES  127 

market,  sell  his  stocks  or  bonds  at  or  near  the  price  he  paid 
for  them.  If  this  assurance  of  safety  of  principal  and  cer- 
tainty of  income  can  be  given  him,  he  is  satisfied  with  a 
moderate  return. 

The  most  important  investors  in  the  United  States  are 
the  financial  institutions,  insurance  companies,  trust  com- 
panies, banks  and  large  estates.  These  institutions  demand 
safety  before  every  other  consideration.  They  are  willing 
to  pay  high  prices  for  stocks  and  bonds  where  the  assurance 
of  safety  can  be  given.  Besides  these  institutions,  the  char- 
acter of  whose  investments  is  determined  not  merely  by 
prudence  but  by  law,  there  are  a  great  majority  of  the 
wealthy  and  well-to-do  people  of  the  country  in  the  invest- 
ing class.  Their  chief  concern  is  to  keep  what  they  have. 
They  demand  of  the  securities,  into  which  they  put  their  sur- 
plus income,  the  highest  degree  of  safety  and  stability,  the 
most  complete  guarantee  of  security.  • 

The  investor  will  buy  government  bonds,  well-secured  rail- 
road bonds  or  guaranteed  stocks  of  railroads,  municipal  bonds, 
bonds  of  street  railways,  electric  light  or  gas  companies  in 
large  cities,  and  the  best  grade  of  railroad,  street  railway  or 
gas  stocks.  Of  later  years,  with  much  diffidence  and  hesita- 
tion, he  has  gone  into  industrials.  The  preferred  stocks  of 
some  of  the  large  concerns  are  now  extensively  held  by  con- 
servative investors.  The  stocks  of  new  industrials,  and  of 
oil  and  mining  companies  he  usually  lets  alone.  This  invest- 
ment demand,  concentrated  upon  a  portion  of  the  securities 
offered  for  sale,  fixes  the  value  of  every  investment,  no  matter 
how  high  may  be  the  return  upon  its  face  value,  at  a  figure 
which  will  allow  to  the  purchaser  only  a  small  return  upon 
the  money  invested.  There  are  few  safe  investments  offered  for 
sale  on  the  New  York  Stock  Exchange  whose  price  when  com- 
pared with  their  yield  in  interest  or  dividends,  shows  a  return 
of  more  than  six  per  cent. 

When  the  investment  banker  is  approached  by  the  pro- 
moters of  a  new  enterprise,  and  asked  to  assist  in  the  flota- 
tion, he  examines  carefully  the  character  of  the  scheme.    The 


128  COKPOKATION   FINANCE 

first  thing  he  demands  of  the  securities  which  are  offered  to 
him,  is  that  they  shall  be  salable.  Unless  he  can  sell  them 
at  a  profit,  he  will  have  nothing  to  do  with  the  scheme. 
Assuming  that  the  securities  are  salable,  the  next  question 
is,  can  he  recommend  them  to  his  own  customers?  It  must 
be  remembered  that  the  relation  of  the  investment  banker 
to  his  customers  is  a  fiduciary  relation.  He  is  a  wholesaler 
of  securities.  By  an  extensive  organization,  covering  some- 
times many  states,  he  keeps  in  touch  with  funds  offered  for 
investment.  He  has  classified  in  his  catalogues  the  names, 
sometimes,  of  many  thousands  of  people  who  buy  securities^ 
he  knows  how  much  money  they  have  to  invest  and  when 
this  money  will  be  available.  He  has  an  organization  of 
salesmen  who  make  regular  visits  to  his  customers,  and  he 
carries  on  an  extensive  correspondence  with  them  to  influence 
their  purchases.  This  business  the  investment  banker  expects 
to  be  permanent.  If  he  sells  a  bond,  maturing  in  ten  years, 
he  has  a  record  of  that  sale,  and  when  the  bond  is  paid  off, 
he  expects  to  be  on  hand  with  a  new  bond  to  take  the  place 
of  the  old  one.  He  aims  to  cultivate,  therefore,  by  every 
means  in  his  power,  the  good  will  of  his  customers.  The 
basis  of  that  good  will,  the  foundation  upon  which  his  busi- 
ness must  rest,  is  the  investment  quality  of  the  securities 
which  he  offers  for  sale.  In  his  literature  and  through  his 
salesmen,  the  banker  lays  primary  emphasis  upon  the  safety 
of  the  securities  which  he  offers.  He  recommends  them  to 
his  customers,  and  ordinarily  he  has  bought  them  himself, 
before  he  offers  them  for  sale.  His  constant  endeavor  is  to 
protect  his  customers  against  loss.  He  will  carry  these  ef- 
forts, in  some  cases,  so  far  as  to  repurchase  bonds  concerning 
whose  security  there  may  be  a  doubt,  or  to  undertake  at  con- 
siderable expense  and  trouble,  the  work  of  reorganizing  bank- 
rupt companies  whose  bonds  he  has  sold,  so  that  they  may 
again  be  put  upon  a  solvent  basis. 

A  man  in  such  a  business  as  this  cannot  recommend  specu- 
lative bonds  or  stocks  to  his  clients.  He  might  indeed  sell 
a  large  amount  of  doubtful  securities  during  a  period  of 


THE   SALE   OF  SECUKITIES  129 

good  times  which  would  be  bought  from  him  by  his  clients 
because  of  their  confidence  in  him,  but  when  depression  over- 
took these  shaky  enterprises  they  would  go  down,  and  with 
them  would  go  the  good  will  of  the  banker's  business.  A 
long  record  of  successful  flotations  is  not  sufficient  to  protect 
a  banking  house  against  the  discredit  of  offering  and  recom- 
mending securities  which  are  not  good,  and  whose  quality 
could  have  been  revealed  by  an  investigation. 

An  illustration  of  the  caution  displayed  by  reputable 
financial  institutions  in  standing  sponsor  for  new  and  untried 
companies,  so  far  as  to  recommend  their  securities,  is  fur- 
nished by  the  following  letter  received  in  answer  to  an  inquiry 
concerning  the  merits  of  a  Mexican  mining  proposition  which 
had  announced  that  subscriptions  to  its  bonds  would  be  re- 
ceived at  a  prominent  trust  company,  large  use  being  made 
of  the  trust  company's  name  in  the  advertisements.  The 
inquiry  addressed  to  the  trust  company  was  as  follows : 

Dear  Sirs:  I  have  received  certain  information  on 

the  proposition  offered  by  the .     These 

reports  are  extremely  interesting,  and  I  have  given 
them  careful  attention.  I  should  like,  however,  to 
have  your  own  opinion  of  the  merits  of  the  debenture 
bonds  as  a  safe  investment. 

The  Corporation  ,  by  its  Vice-President,  Mr. 

,  has  heartily  recommended  them,  and  I  presume 

you  will  have  no  hesitation  in  confirming  his  state- 
ment that  he  believes  them  to  be  a  safe  and  profitable 
investment. 

The  reply  of  the  trust  company  is  as  follows : 

Dear  Sir  :  We  have  your  favor  of  the  18th  inst.  In 
reply  thereto  would  say  that  following  our  invariable 
policy,  we  regret  our  inability  to  advise  you  in  the 
matter  of  the  investment  referred  to.  Our  duty  is 
merely  to  receive  such  subscriptions  as  may  be  ten- 
dered  on   behalf   of  the  ,   and 

we  have  been  selected  to  countersign  the  bonds.  The 
parties  interested  in  the  matter  have  come  to  us  prop- 
erly recommended. 


130  CORPORATION   FINANCE 

The  statements  contained  in  the  advertisement  and 

circulars  are  the  statements  of  the  and  not 

of  this  Company. 

Yours  very  truly, 

(Signed) , 

Second  Vice  President. 

If  the  securities  of  the  new  company  are  of  a  speculative 
character,  it  is  evident  that  the  banker  cannot  purchase  them 
directly  and  offer  them  as  his  own  property  to  his  customers. 
He  can,  however,  insure  or  guarantee  their  sale.  The  trust 
company  just  mentioned  would  have  been  interested  in  these 
bonds  at  its  own  risk,  or  by  lending  to  officers  and  directors 
on  the  security  of  the  bonds,  without  openly  indorsing  them, 
unless  the  use  of  its  name  as  the  depositary  of  the  mining 
company  may  be  regarded  as  an  indorsement. 


CHAPTER   XI 
THE  SALE  OF  SPECULATIVE  SECURITIES 

If  the  securities  of  a  new  corporation  cannot  be  sold  to 
the  banker  for  resale  to  the  investor  they  must  be  sold  direct 
to  the  speculative  public.  The  most  conspicuous  illustration 
of  the  methods  successfully  employed  to  provide  large  sums  of 
money  within  a  short  time  by  selling  stocks  and  bonds 
of  doubtful  investment  quality  to  the  general  public  is  fur- 
nished by  the  sale  of  industrial  securities  from  1898  to  1902. 
We  have  already  considered  the  circumstances  under  which 
the  so-called  trusts  were  promoted  and  have  examined  into 
their  organization  and  the  advantages  which  their  promoters 
claim  for  them.  Chief  among  these  advantages  was  the  re- 
striction of  competition  out  of  which  it  was  expected  that 
large  profits  would  be  earned. 

In  the  formation  of  these  consolidations  a  large  amount 
of  cash  had  to  be  provided  for  the  purchase  of  properties 
whose  owners  would  not  accept  stock  in  the  consolidation  and 
for  working  capital.  This  cash,  moreover,  had  to  be  produced 
within  a  short  time  and  it  became  necessary  to  dispose  of 
several  billions  of  dollars  par  value  of  stocks  and  bonds  and 
its  provision  was  essential  to  the  launching  of  the  new  com- 
panies. In  nearly  every  case,  arrangements  were  made  with 
banking  houses  who  organized  underwriting  syndicates  which 
guaranteed  the  sale  of  these  issues  of  industrial  stocks  and 
bonds  at  prices  sufficiently  below  the  price  which  they  ex- 
pected would  be  realized,  to  leave  them  a  large  profit.  These 
underwriting  syndicates  did  not  expect  to  be  permanently 
interested  in  the  new  enterprise  and  had  large  blocks  to  dis- 

131 


132  CORPORATION  FINANCE 

pose  of.  The  promoters,  whether  individuals  or  syndicates, 
had  large  quantities  of  securities  for  sale.  The  owners  of 
the  companies  which  entered  the  consolidations  had  also 
large  amounts  of  securities  to  sell,  especially  common  stock. 
These  owners  were  usually  obliged  to  wait  before  offering 
their  stock  for  sale  until  the  syndicate  manager  had  disposed 
of  his  holdings,  or  until  the  syndicate  had  been  dissolved. 
As  soon  as  their  contracts  with  the  syndicate  manager  per- 
mitted, a  large  amount  of  the  stock  issued  for  the  stock  of 
the  constituent  companies  was  offered  for  sale.  It  was,  in 
short,  necessary  that  several  billions  of  dollars  par  value  of 
industrial  stocks  should  be  sold  within  a  comparatively  short 
time.  An  examination  of  the  stocks  of  the  industrial  trusts 
was  sufficient  to  convince  any  intelligent  investigator  that  at 
the  time  of  their  issue  they  were  not  entitled  to  rank  as  invest- 
ments. In  an  editorial  under  date  of  August  15,  1900,  the 
Wall  Street  Journal  submits  a  list  of  questions  from  the 
answers  to  which  the  buyers  of  securities  may  form  an  opinion 
as  to  the  investment  standing  of  the  trust  stocks.  The  sub- 
stance of  these  questions  is  as  follows : 

1.  What  were  the  plants  able  to  earn  on  the  average  for 
the  five  years  preceding  the  combination  ? 

2.  What  would  this  amount  have  paid  on  the  present 
amount  of  stock? 

3.  How  much  have  expenses  been  reduced  by  consoli- 
dation ? 

4.  How  much  have  gross  earnings  been  increased  by 
consolidation  ? 

5.  What  will  the  combination  have  to  earn  net  in  order 
to  pay  seven  per  cent  on  its  preferred  stock? 

6.  How  much  in  excess  of  that  amount  is  the  company 
earning  now  ? 

7.  What  is  the  amount  of  the  net  floating  debt? 

8.  How  is  this  floating  debt  secured? 

9.  Is  the  corporation  hampered  by  burdensome  contracts  ? 

10.  Can  it  enforce  its  own  contracts  with  buyers  ? 

11.  What  is  the  extent  of  the  competition  encountered? 


SALE   OF   SPECULATIVE   SECUEITIES        133 

12.  What  is  the  possibility  of  reducing  operating  expenses  ? 

13.  Is  the  management  in  every  way  competent  and  sat- 
isfactory ? 

Here  is  presented  an  outline  for  an  investment  judgment. 
If  these  questions  can  be  fully  answered,  the  investor  can 
determine  with  some  accuracy  whether  the  trust  stocks  can 
be  safely  purchased.  If  the  trust  has  a  large  annual  surplus 
of  profits  over  its  dividends,  declared  or  reserved;  if  its  un- 
secured debt  is  kept  within  manageable  limits;  if  the  reports 
of  its  physical  condition,  its  earnings,  its  assets  and  liabilities 
are  frequent  and  circumstantial,  and  if  it  has  maintained 
by  wise  and  energetic  management  a  dominant  position  in  the 
trade,  the  investor  may  safely  put  his  money  into  its  stocks. 
His  security  would  not  be  as  good  as  the  security  which  a 
general  mortgage  bond  would  give  him,  but  he  would  receive 
a  higher  return,  probably  5^  or  6  per  cent,  and  by  carefully 
watching  his  investment,  he  would  be  tolerably  safe  against 
loss.  If  the  syndicate  manager  would  give  the  informa- 
tion asked  for,  and  if  the  condition  of  the  new  corporation 
was  shown  to  be  satisfactory,  an  investment  demand  would 
spring  up  for  its  stocks. 

But  all  of  these  questions  could  not,  in  the  nature  of  the 
case,  be  answered.  The  trust  had  just  come  into  being.  If 
the  promoter  had  been  frank  with  the  public,  the  net  earnings 
of  the  plants  for  the  preceding  three  years  were  given  in  his 
prospectus.  It  may  appear  that  the  amount  of  preferred 
stock  issued  is  warranted  by  the  net  earnings,  and  this,  be 
it  noted  to  the  credit  of  the  promoters,  had  been  usually 
true  of  their  preferred  stock  issues.  But  this  fact  only 
answers  two  out  of  thirteen  questions  on  which  the  investor 
must  have  information  before  making  a  conservative  judg- 
ment. The  remaining  eleven  could  not  be  answered  for  per- 
haps five  years,  or  until  the  trust,  in  a  period  of  industrial 
depression,  had  proved  the  strength  of  its  organization  and 
the  skill  of  its  management.  The  trust,  at  the  time  its 
stocks  are  offered  for  sale,  had  no  expenses  to  reduce;  it  had 
not  attempted  to  increase  its  earnings;  if  it  had  a  floating 
10 


134  COKPOKATION   FINANCE 

debt,  this  was  composed  of  the  unsecured  debts  of  underlying 
companies — not  usually  published — in  the  new  company  there 
had  been  no  occasion  to  incur  debts ;  the  value  of  its  contracts 
and  its  power  over  buyers  were  to  be  determined  by  future 
experience;  the  strength  of  the  competition  was  uncertain, 
and  the  quality  of  its  management  under  these  new  condi- 
tions had  not  been  determined.  The  prospective  investor 
was  left  in  the  dark  concerning  these  matters.  There  were 
great  speculative  possibilities  in  the  trust  proposition,  but  he 
could  not  make  an  investment  judgment  as  to  the  probability 
of  their  realization. 

The  investor,  moreover,  when  he  looked  into  the  merits 
of  the  trust  stocks,  was  confronted  with  many  doubts  and 
fears.  What  would  be  the  attitude  of  the  public  toward  the 
trust?  Would  its  management  be  left  unhampered  to  work 
out  the  possibilities  of  reduced  expenses  and  more  stable 
prices,  or  would  the  cry  of  monopoly  be  raised  and  popular 
sentiment  take  hostile  form  in  special  taxes,  reduced  tariffs, 
or  assaults  upon  the  corporation's  right  to  exist  ?  Would  the 
public  pay  higher  prices,  or  would  they  purchase  cheaper 
substitutes?  Had  not  the  corporation,  in  issuing  cumulative 
preferred  stock,  endangered  its  future  by  the  compelling  ne- 
cessity of  paying  dividends  on  the  preferred  in  order  to 
protect  the  common  ?  These  were  some  of  the  considerations, 
in  addition  to  the  lack  of  most  of  the  information  on  which 
he  had  been  accustomed  to  base  his  judgment,  which  warned 
the  conservative  investor  not  to  buy  the  trust  stocks. 

Even  the  preferred  stock,  based,  as  its  value  was  supposed 
to  be,  on  past  earning  power  was  not  assured  of  dividends  in 
the  future.  A  new  management  had  been  placed  in  control, 
and  this  past  earning  power  might  not  be  sustained.  Bonds 
or  floating  debt  might  be  placed  ahead  of  the  preferred  stock 
to  absorb  the  earnings  which  were  to  go  to  that  security.  The 
cumulative  feature,  for  which  so  much  has  been  claimed, 
might  prove  a  source  of  weakness  rather  than  strength.  If 
unpaid  dividends  should  accumulate,  the  value  of  the  com- 
mon stock  might  be  obliterated,  and  this  might  seriously 


SALE   OF   SPECULATIVE   SECURITIES        135 

damage  the  financial  standing  of  the  company.  It  might 
even,  at  a  critical  moment,  deprive  the  corporation  of  a  loan 
which  would  save  it  from  bankruptcy.  As  for  the  common 
stock,  burdened  as  it  was  by  the  extraordinary  advantages 
which  are  given  to  the  senior  security,  it  had  nothing  to  com- 
mend it.  If  the  investor  could  not  safely  invest  in  the  pre- 
ferred shares,  he  would  certainly  have  nothing  to  do  with  the 
common. 

The  syndicate  manager  could  not  count  upon  selling  his 
stocks  to  the  investor  who  buys  only  on  the  satisfaction  of 
an  intelligent  Judgment,  either  his  own  judgment  or  that  of 
his  broker  or  banker,  that  the  stocks  into  which  he  puts  his 
money  will  yield  a  certain  and  stable  return,  and  above  all, 
that  he  can  be  certain  of  selling  the  stock  for  the  price  at 
which  it  was  purchased.  No  such  claims  could  properly  be 
made  for  the  trust  stocks.  Their  dividends  were  uncertain, 
prospective,  problematical.  They  started  with  bright  pros- 
pects, it  is  true,  but  these  prospects  might  never  be  realized. 
The  conservative  investor  would  have  none  of  them. 

Cut  off  from  recourse  to  the  investment  demand,  the 
syndicate  manager  made  his  appeal  to  the  speculators.  They 
are  usually  persons  of  moderate  means  who  are  willing  to 
buy  the  shares  of  new  companies  at  low  prices',  trusting  in 
the  representations  of  those  who  have  stocks  to  sell,  that  these 
stocks  will  pay  large  dividends  and  eventually  increase  in 
value.  The  speculative  buyer  has  usually  no  knowledge  of 
finance.  He  does  not  understand  the  nature  of  an  invest- 
ment judgment.  He  thinks  of  a  stock  as  $100  and  regards 
its  dividends  as  certain  and  permanent.  He  has  no  skill  in 
offsetting  advantages  with  disadvantages.  With  him  a  secur- 
ity is  either  good  or  bad.  There  is  no  halfway  point.  If  the 
syndicate  manager  had  set  before  him  all  the  materials  for 
an  investment  judgment  of  the  trust  proposition,  he  could 
not  have  made  such  a  judgment.  If,  moreover,  the  difficulties 
and  uncertainties  which  deter  the  investor  from  bu3dng  trust 
stocks  had  been  presented  to  the  speculative  buyer,  he  would 
have  been  frightened  away.    If  these  negative  considerations 


136  COEPOKATION   FINANCE 

are  not  presented,  however,  he  will  not  ask  for  them  nor  will 
he  suspect  their  existence.  Great  care  must  therefore  be  taken 
to  give  him  only  the  most  simple  and  favorable  information 
concerning  the  stock  which  it  is  designed  that  he  should  buy. 
The  "  public  "  asks  few  questions — save  as  to  the  standing  of 
the  oflScers  and  directors  of  the  new  company,  for  they  natur- 
ally do  not  want  to  be  robbed — and  the  amount  of  dividends 
which  is  promised  to  its  stockholders.  It  is  from  this  class 
of  buyers  that  a  portion  of  the  funds  which  are  to  reimburse 
the  advances  of  the  underwriter  are  to  come. 

There  is,  it  is  true,  another  method  which  might  be  sug- 
gested in  such  cases,  and  which,  if  successful,  would  have 
enabled  the  trust  stocks  to  be  originally  sold  to  the  investor. 
The  promoters  and  underwriters  might  have  held  their  stock, 
foregoing  their  profits  for  three  or  five  years,  and  might 
require  the  vendors  to  do  the  same.  At  the  end  of  this  period, 
if  the  calculations  of  the  promoters  to  which  the  underwriter 
had  fixed  his  indorsement  proved  to  have  been  accurate,  the 
securities  which  had  been  held  off  the  market  pending  this 
verification  could  have  been  sold  to  the  investor  at  good 
prices.  The  corporation  law  of  Gfermany,  as  we  have  seen, 
attempts  to  secure  this  confirmatory  delay  by  prohibiting  the 
listing  of  shares  on  the  exchanges  until  one  year  from  the 
date  of  the  organization  of  the  company.  A  longer  time  was 
needed  to  establish  a  new  form  of  industrial,  such  as  the 
trust,  in  the  confidence  of  the  investor. 

This  delay,  however,  although  desirable  from  the  stand- 
point of  conservative  investment  judgment,  is  not  contem- 
plated by  financiers  of  new  companies.  Not  only  would  it 
be  unreasonable  to  demand  of  them  such  a  degree  of  self- 
denial,  but  the  enforcement  of  such  a  regulation,  it  is  safe 
to  say,  would  make  impossible  the  financing  of  speculative 
projects  on  a  large  scale.  The  underwriter  would  demand 
a  prohibitive  commission,  and  the  promoter  would  have  little 
inducement  to  bring  forward  large  projects,  if  both  interests 
were  obliged  to  wait  for  several  years  before  selling  their 
stocks.     To  require   such   a  delay,  moreover,  would  be  to 


SALE   OF   SPECULATIVE   SECURITIES        137 

destroy  the  function  of  the  underwriter  as  the  retailer  of 
speculative  securities  from  the  promoter  to  the  public.  It 
would  compel  the  underwriter,  if  he  put  his  money  into  any 
project,  to  regard  it  as  a  permanent  investment;  that  is  to 
say,  to  abandon  his  character  of  banker,  and  assume  that  of 
investor,  whose  profits,  at  least  for  several  years,  must  come 
from  interest  or  dividends.  As  an  investor,  however,  the 
underwriter  would  demand  the  information  necessary  to  an 
investment  judgment,  and  this  information  the  promoter  of 
a  new  form  of  enterprise  such  as  the  trust,  is  usually  unable 
to  furnish. 

We  are  brought,  therefore,  to  the  conclusion  that  the 
financing  which  was  necessary  in  the  formation  of  the  in- 
dustrial trusts  could  not  have  been  secured  if  those  who  fur- 
nished the  cash  had  been  required  to  realize  their  profits  from 
selling  the  securities  which  they  received  to  the  investor  who 
demands  the  conviction  of  safety  before  parting  with  his 
money.  Or,  to  put  the  matter  in  another  way,  underwriters, 
as  prudent  men  would  not  put  their  money  into  the  stocks 
of  the  industrials  without  a  reasonable  certainty  that  these 
funds  could  be  recovered  with  a  profit  in  addition  by  selling 
the  stocks  to  the  general  public.  In  short,  the  underwriter 
of  speculative  stocks  or  bonds  asks  the  public  to  buy  stocks 
for  investment  which  he  would  not  buy  for  himself.  Only 
in  this  way  can  money  be  raised  for  new  and  risky  projects. 

The  main  recourse  of  the  syndicate  manager  of  the  trust 
was  to  the  speculator,  and  he  was  fortunate  that  he  could 
draw  upon  a  reservoir  of  funds  which  was  full  to  overflowing. 
The  methods  by  which  he  exchanged  his  trust  stocks  for  cash 
we  have  now  to  consider. 

The  first  step  in  the  process  of  selling  stock  to  a  specula- 
tive buyer  is  to  excite  his  imagination.  There  must  be  placed 
before  him  a  picture  of  enormous  wealth  in  which  he  is 
invited  to  share.  In  actual  existence  as  yet  there  is  nothing 
save  a  flat  plain,  a  precipitous  mountain,  or  a  prospect  of 
monopoly  profits.  The  speculator  must  furnish  the  money 
to  ascertain  what  lies  below  the  surface,  and  if  there  is  any- 


138  CORPORATION   FINANCE 

thing  found,  to  develop  it.  But  in  order  that  the  speculator 
shall  advance  these  funds,  he  must  be  made  to  disregard  the 
present  and  project  his  gaze  into  the  future.  He  must  behold, 
as  does  one  in  a  vision,  a  fully  equipped  mining  property  or 
oil  well,  and  he  must  see  himself  as  part  owner  of  this  valu- 
able property.  In  view  of  this  necessity,  the  general  arrange- 
ment of  a  prospectus,  no  matter  of  what  enterprise  it  treats, 
is  always  the  same.  Th6  project  contains  some  new  feature 
— a  new  resource,  a  new  invention,  a  new  form  of  industrial 
organization,  oil  lands  in  California,  copper  land  in  Arizona, 
real  estate  on  the  frontier  of  Brooklyn,  or  options  on  com- 
peting plants.  The  development  of  these  resources  and  op- 
portunities is  to  be  followed  by  large  earnings. 

The  reasons  for  this  belief  are  forcibly  set  forth  in  a 
prospectus.  The  mine  is  either  directly  adjoining  a  fully 
developed  property  which  is  paying  large  dividends,  or  the 
geological  indications  point  unmistakably  to  the  existence  of 
a  resource  of  great  value.  Similar  enterprises  in  other  parts 
of  the  country  have  proved  enormously  profitable.  The  pres- 
ent scheme  is  fundamentally  identical  with  these  enterprises. 
There  the  present  scheme  will  be  equally  successful. 

A  mass  of  expert  testimony  of  this  or  that  "  professor," 
whose  wealth  of  technical  detail  is  most  convincing,  is  usually 
added.  Note,  for  example,  the  following  extract  from  an 
expert's  opinion  of  the  Monterey  district :  "  .  .  .The  geologi- 
cal formation  of  the  oil-bearing  strata  and  extensive  surface 
indications  of  petroleum  seem  to  indicate  the  certainty  of 
there  being  productive  resources  of  oil  below.  Sandstone  and 
shale  of  a  bituminous  character  seem  to  be  the  general  surface 
indications  of  petroleum.  There  are  apparently  three  anti- 
clinal ridges  extending  through  this  range  which  the  oil 
belts  seem  to  follow.  Judging  from  the  croppings,  the  west 
side  of  the  Salines  Valley  contains  a  vast  oil  reservoir.  I 
have  formed  this  conclusion  on  account  of  the  immense  depth 
and  thickness  of  the  oil-bearing  sands  and  also  the  immense 
beds  of  bituminous  shale."  Perhaps  the  "  professor "  has 
a  record  of  success  to  enforce  his  statements.    He  may  "  stake 


SALE   OF   SPECULATIVE   SECUKITIES        139 

his  reputation  "  on  the  success  of  this  last  project  which  he 
indorses,  and  which  he  believes  to  be  "  far  richer  than  United 
Verde/'  a  mine  which  paid  $2,924,000  in  dividends  in  one 
year. 

Accompanying  the  expert's  reports  will  be  maps  and 
charts  showing  the  exact  location  of  the  property,  if  the  prop- 
osition is  for  a  mining  or  oil  enterprise,  in  relation  to  pro- 
ducing mines  or  wells,  these  latter  being  always  in  the  im- 
mediate neighborhood  of  the  land  of  the  new  company  or 
else  "  the  geological  formation  on  this  claim  is  identical  with 
that  found  on  the  largest  dividend  paying  properties  in  the 
districts."  The  National  and  State  Geographical  Surveys 
are  dragged  in  to  support  the  expert  testimony. 

Newspaper  accounts  of  the  "  fabulous  richness  of  the 
Kootenay  country,"  or  "  Wonderful  Tonopah,  a  Desert  Camp 
of  Fabulous  Richness,"  written  for  local  newspapers,  or  the 
more  sober  narratives  of  the  metropolitan  journals,  also  excite 
the  imagination  of  the  speculator.  Such  news  items  as  the 
following  appear  in  metropolitan  journals :  "  Nevada,  Jan- 
uary 27th — At  the  Tonopah  camp  the  most  impressive  things 
are  the  huge  stacks  of  ore  awaiting  shipment.  Henry  Cut- 
ting, who  came  into  the  camp  early  last  year  with  only  $2.50 
in  his  pocket,  has  one  stack  which  is  estimated  to  be  worth 
$500,000.  Another  man  who  has  been  very  lucky  is  Frank 
Golden,  who  has  a  great  stack  of  sacks  of  ore  like  a  fort, 
which  is  worth  $700,000." 

Strongly  worded  testimonials  may  be  added  to  the  schedule 
of  evidence.  The  project  is  backed  by  substantial  business 
men,  often  by  men  of  national  reputation — won  in  some  other 
field — who  publicly  advise  their  friends,  as  did  an  ex-governor 
of  a  Western  State,  to  "  provide  for  the  children  "  by  invest- 
ing a  few  dollars  in  rubber  certificates.  The  best  of  bank 
references  are  also  given. 

All  this  mass  of  skillfully  arranged  data  leading  the  mind 
almost  imperceptibly  from  the  known  to  the  unknown,  em- 
phasizing advantages  to  the  point  of  exaggeration,  glossing 
over  difficulties  or  preferably  remaining  silent  about  them, 


140  COKPOEATION   FINANCE 

marshaling  history,  science,  and  reputation  to  the  support 
of  prophecy — all  these  specious  and  forceful  arguments  are 
directed  to  the  end  of  creating  in  the  mind  of  the  prospective 
buyer  a  vision  of  enormous  wealth.  It  is  but  seldom  that 
they  fail  to  accomplish  the  result.  If  it  were  possible,  a 
sympathetic  examination  of  their  literature  would  deceive 
the  very  elect. 

Cupidity  is  the  next  passion  to  which  the  promoter  ap- 
peals. The  stock  in  these  companies  whose  prospects  of  large 
profits  are  so  well  assured,  is  offered  at  a  low  price,  50 
cents,  $1  or  $2.50,  per  share,  some  indeed  as  low  as  five 
cents  a  share.  The  company  issuing  the  stock,  it  is  stated, 
is  in  possession  of  a  resource  of  enormous  value.  Only  a 
small  amount  of  money  is  needed  to  develop  the  mine  or 
drill  the  well — "  in  order  to  facilitate  the  development  of 
the  valuable  lands  of  this  company,  the  directors  have  placed 
on  the  market  a  limited  amount  of  its  treasury  stock  to 
be  sold  at  the  special  introductory  price  of  twenty  cents  per 
share,  and  the  company  reserves  " — mark  this,  opportunity 
only  knocks  once — "  the  right  to  advance  the  price  of  the 
same  without  notice."  After  the  initial  expenditure,  it  is 
claimed,  the  enterprise  will  grow  out  of  its  own  earnings. 

And  its  assured  dividends.  "  Marvelous  and  monstrous  " 
is  the  only  phrase  that  adequately  describes  them.  It  is  a 
poor  company  that  cannot  assure  the  investor  twenty  per 
cent  on  his  money.  Note,  for  example,  the  following :  "  The 
value  of  this  stock  as  an  investment  may  readily  be  seen  when 
it  is  understood  that  one  well  producing  100  barrels  of  oil 
daily  will  earn  four  per  cent  on  the  entire  capitalization,  or 
twenty  per  cent  on  the  present  selling  price  of  the  stock." 
The  company  in  question  had  room  for  150  wells  on  its 
property  and  the  inference  of  the  prospectus  is  that  dividends 
of  1,000  per  cent  on  the  investment  are  by  no  means  out  of 
the  question. 

If  the  speculator  asks  for  conclusive  evidence  that  these 
huge  dividends  will  be  paid — let  him  look  to  the  record  of 
other  enterprises  which  had  at  the  outset  no  better  prospects 


SALE   OF   SPECULATIVE   SECUKITIES        141 

than  that  into  which  he  is  asked  to  put  his  money.  "  In  one 
instance,  about  one  and  one  half  years  ago,  $1,200  was  in- 
vested in  three  sections  of  oil  land  in  one  oil  district.  To-day 
these  same  lands  are  worth  $5,000,000.  In  another  instance 
$3,200  was  invested  in  two  sections.  To-day  these  two  sec- 
tions are  worth  $6,000,000."  Specimen  advances  in  oil 
stocks  are  given — for  example :  "  The  New  York  Oil  Com- 
pany sold  at  fifty  cents  per  share,  present  market  price  $200  " ; 
or  "the  Home  Oil  Company  sold  at  $10  per  share,  present 
market  price  $5,000."  Or,  if  the  proposition  is  in  gold  or 
copper  mining,  figures  like  this  are  given :  "  United  Verde 
once  sold  for  fifty  cents  a  share  and  is  now  paying  nearly 
8,700  per  cent  on  that  price.  The  LeKoi  Mine  was  sold 
entire  in  1890  for  $12.50;  it  now  has  a  market  value  of  $10,- 
000,000 — $100  invested  in  LeRoi  a  few  years  ago  is  now 
worth  $250,000  and  has  paid  $35,000  in  dividends.  Alaska 
Treadwell  has  paid  $5,000,000  in  dividends  and  its  stock 
has  advanced  3,200  per  cent,"  etc.,  etc.  Evidence  of  this 
character  is  abundant  and  effective. 

If  doubt  is  expressed  as  to  the  future  demand  for  these 
products  even  should  they  be  successfully  produced,  the  pro- 
spectus is  ready  with  assurance  that  "  the  development  of 
California  will  demand  all  the  oil  that  can  be  produced"  or 
"  the  electrical  industry  will  continue  to  exhaust  the  supply 
of  copper."  Nothing  is  left  uncovered.  Every  detail  is  at- 
tended to.  A  chance  to  draw  a  valuable  prize  is  offered  at 
a  low  price. 

The  whole  argument  is  summed  up  with  convincing 
brevity  by  a  copper  prospectus.  "  Bell  telephone  was  given 
away  for  board  bills,  yet  has  paid  over  $36,000,000  in  divi- 
dends. Calumet  and  Heckla  went  begging  not  so  many 
years  ago;  its  total  dividends  to  date  are  over  $60,000,000. 
It  would  take  a  day  to  enumerate  the  instances  where  prop- 
erties rich  and  great  to-day  were  offered  for  a  song.  The 
people  who  did  buy  them  are  rich  now,  and  why?  Not  be- 
cause they  were  '  lucky,'  but  because  they  investigated 
promptly,  judged  the  merit  of  the  proposition,  and  acted 


142  COKPORATION   FINANCE 

while  there  was  time.  If  they  had  waited  until  to-day  to 
buy  the  shares  of  these  enterprises  they  would  get  perhaps 
five  per  cent  on  their  money,  possibly  eight,  but  no  more. 
But  buying  when  they  did,  they  got  all  the  way  from  fifty 
per  cent  up  to  500  per  cent  because  they  had  both  the  judg- 
ment to  recognize  the  worth  of  the  opportunity  and  the 
courage  to  seize  it.  A  thorough  examination  of  the  details 
of  the  Arizona  Copper  Syndicate  will  satisfy  any  man  of 
judgment  as  to  its  merits.  It  is  one  of  the  greatest  opportu- 
nities ever  given  investors.  Investigate  it  now  while  the  price 
is  low." 

Here  are  the  principal  inducements  offered  to  the  specu- 
lator in  every  new  enterprise.  Other  men  have  made  money 
in  similar  enterprises.  Why  should  not  he  be  equally  for- 
tunate? He  is  not  asked  to  gamble,  but  merely  to  investi- 
gate an  industrial  opportunity  and  act  as  his  judgment 
directs.  He  is  carried  away  by  the  prevailing  optimism  of 
the  time,  and  he  is  ready  to  listen  to  the  advocates  of  new 
schemes  for  getting  rich.  Other  people  are  making  money 
fast,  and  he  is  certain  of  his  ability  to  do  as  well  as  they. 
The  appeal  to  his  "judgment"  and  his  "courage"  is  the 
bit  of  flattery  which  is  often  decisive,  and  the  final  outcome 
is  that  the  man  of  small  means  invests  $100,  $200,  or  $5,000 
in  the  stock  of  a  new  company  in  the  confident  expectation 
that  from  this  small  investment  he  will  one  day  reap  a 
fortune. 

When  once  embarked  on  a  doubtful  enterprise,  the  specu- 
lator is  impelled  by  sentiment  and  interest  to  draw  others 
along  with  him.  The  speculator  is  by  instinct  a  promoter. 
He  is  zealous  in  advocacy  of  this  project  to  which  he  has 
committed  his  money.  "  He  urges  upon  his  friends  the  merits 
of  the  new  scheme.  His  enthusiasm  is  infectious.  Others 
are  drawn  into  the  net  by  his  representations,  and  they  in 
turn  compass  sea  and  land  to  make  one  proselyte.  In  this 
way  the  wave  of  speculation  is  set  going  and  sweeps  through 
all  classes  of  society,  turning  the  accumulations  of  years 
of  effort  into  the  treasuries  of  the  new  companies. 


SALE   OF   SPECULATIVE   SECURITIES        143 

The  situation  is  universally  familiar.  A  minister  or  a 
physician  has  a  few  thousands  laid  by;  a  woman  has  either 
saved  or  inherited  a  small  amount;  a  workman  or  a  farmer 
has  managed  to  scrape  together  something  for  a  rainy  day. 
Such  people  are  found  by  the  thousands  in  every  part  of  the 
country.  From  their  accumulations  they  draw  a  small  rate 
of  return,  often  so  small  that  they  are  constrained  to  add 
it  to  the  principal  and  do  not  venture  to  apply  it  to  ex- 
penditures. Four  or  five  per  cent  clear  gain  is  about  all  that 
can  be  expected.  Their  lives  are  hard,  monotonous,  and 
barren.  Before  their  eyes  is  constantly  flaunted  the  luxurious 
extravagance  of  the  wealthy  leisure  class.  To  such  people 
the  prospectus  of  a  new  enterprise  is  wonderfully  attractive. 
In  exchange  for  a  few  thousand  it  offers  them  a  fortune. 
The  offer  dazzles  them.  Their  desires  benumb  their  judgment. 
The  risk  of  the  undertaking  is  forgotten.  Few  of  those 
who  put  their  money  into  a  speculative  scheme  enter  it  with 
the  thought  of  risk.  The  calm  balancing  of  chances  is  the 
exercise  of  a  superior  order  of  mind.  The  speculator  does  not 
buy  a  chance,  he  buys  what  he  thinks  is  a  fortune.  He  has 
had  a  vision  of  a  vein  of  ore  or  a  great  reservoir  of  oil.  He 
has  seen  a  populous  town  arise  around  the  factory  in  which 
he  has  invested.  He  has  forsaken  the  difficult  paths  of  rea- 
son for  the  flowery  fields  of  imagination  and  conjecture. 

The  line  of  speculators  is  very  ancient.  In  1720  there 
was  printed  for  W.  Bonham,  in  London,  "  an  argument  prov- 
ing that  the  South  Sea  Company  is  able  to  make  a  dividend 
of  thirty-eight  per  cent  for  twelve  years,  fitted  to  the  mean- 
est capacities."  This  was  one  of  the  first  prospectuses  ever 
issued,  and  the  succession  has  been  worthy  of  its  ancestor; 
Spanish  Jackass  Company,  Louisiana  Bubble,  South  Amer- 
ican Bonds,  American  Improvement  Bonds,  English  Rail- 
ways, American  Railways,  American  Mines,  South  Amer- 
ican Railways,  Australian  Railways,  Band  Mines,  American 
Industrials— John  Law,  Hudson,  Barnato,  Hooley,  Gates, 
and  Lawson.  The  line  runs  true.  The  Jackass  Company 
still  lives. 


CHAPTER    XII 
THE    SALE    OF   SPECULATIVE    SECVRITIES— (Continued) 

The  foregoing  presents  in  brief  outline  the  methods  of 
selling  stock  in  an  enterprise  which  is  on  its  face  so  danger- 
ously risky  as  to  require  the  most  spectacular  representa- 
tions and  the  most  flamboyant  promises  in  order  to  work 
the  speculator  up  to  the  point  of  shutting  his  eyes  to  the 
risk  and  going  in  on  faith  alone.  Hundreds  of  these  com- 
panies are  floated  every  year,  and  their  promoters  often  find 
good  markets  for  their  wares.  Most  of  these  promoters  are 
honest.  They  expect  to  spend  a  large  part  of  the  funds  in- 
trusted to  their  care  in  the  exploitation  of  the  resource  or 
opportunity  which  they  control.  A  minority  are  fraudulent. 
But,  one  and  all,  they  must,  in  order  to  float  their  schemes, 
appeal  to  the  imagination  and  the  cupidity,  and  blindfold 
the  judgment  of  the  people  who  buy  their  shares.  All  that 
they  can  properly  offer  is  a  chance  in  a  lottery  in  which 
there  are  few  prizes  and  many  blanks. 

But  how  do  the  foregoing  statements  apply  to  the  ques- 
tion in  hand?  The  industrial  trust  was  a  very  different 
enterprise  from  the  Arizona  Copper  Syndicate.  There  was 
apparently  nothing  in  common  between  them.  The  syndi- 
cate manager  of  the  trust  was  a  great  banker  whose  name  is 
a  certificate  of  reputability.  He  fathers  no  wildcat  schemes. 
The  man  with  "  sixty  acres  of  oil  land  adjoining  the  land 
of  the  Standard  Oil  Company  "  would  get  no  recognition 
from  the  head  of  the  underwriting  syndicate.  His  appeal 
was  made  to  the  "  investor  "  not  to  the  oil  or  copper  specu- 
lator. The  trust  promoters  had  organized  the  wire  mills 
or  the  paper  mills  of  the  United  States  into  great  corpora- 
144 


SALE   OF   SPECULATIVE   SECURITIES        145 

ttons  whose  constituent  companies  had  already  succeeded 
in  their  individual  capacities  and  whose  profits  must  be  far 
greater  now  that  competition  had  been  eliminated.  There 
was  no  manner  of  doubt  about  it.  There  were  the  properties; 
their  value  had  been  carefully  investigated  by  expert  ac- 
countants, and  the  economies  of  combination  were  known. 
The  underwriters  were  men  of  the  highest  responsibility. 
With  such  a  proposition  there  was  no  need  to  beat  the 
tomtoms.  A  brief  official  statement  was  suflficient.  Here 
is  the  trust  prospectus: 

The  International  Paper  Company,  of  New  York, 
was  incorporated  January  1,  1898.  It  at  once  took 
over  by  purchase  twenty-five  of  the  principal  pulp  and 
paper  mills  of  the  country,  which  produce  from  sev- 
enty-five to  ninety  per  cent  of  all  the  newspaper  manu- 
factured east  of  Chicago.  The  average  daily  output 
of  these  mills  is:  Ground  wood  pulp,  1,050  tons  per 
day;  sulfite  pulp,  256  tons  per  day;  finished  paper 
(nearly)  1,500  tons  per  day.  The  leading  manufac- 
turers retain  their  interest  in  the  industry,  and  many 
of  them  are  giving  their  time  and  energy  to  the  pro- 
motion of  the  business  of  the  new  company. 

The  company  has  issued  the  following  securities, 
the  large  majority  of  which  have  been  used  in  pay- 
ment for  the  mills,  water  power,  and  woodlands  ac- 
quired by  the  new  corporation:  first  consolidated 
mortgage  six-per-cent  gold  bonds,  $10,000,000;  pre- 
ferred stock,  cumulative  six  per  cent,  $25,000,000; 
common  stock,  $20,000,000.  The  appraised  value  of 
the  property  securing  the  above-named  bonds  is  $40,- 
000,000.  Net  earnings  are  now  more  than  sufficient 
to  pay  the  interest  on  the  bonds,  dividends  on  the 
preferred  stock,  and  ten  per  cent  on  the  common 
stock;  while  the  indications  fully  sustain  the  belief 
that  they  will  be  even  higher  in  the  future.  Regard- 
ing competition,  it  can  hardly  be  expected  to  prove 
successful,  if  attempted,  for  the  valuable  water  power 
and  timber  lands,  400,000  acres  of  the  latter  being 
held  by  the  company,  could  not  be  easily  duplicated  or 
acquired. 


146 


COKPORATION   FINANCE 


Observe  the  modest  confidence  of  this  statement.  Conk- 
petition  is  destroyed.  A  great  monopoly  is  instituted.  This 
monopoly  is  secured  by  the  possession  of  water  power  and 
timber  lands.  The  leading  manufacturers,  men  who  have 
already  succeeded  in  the  paper  business,  bring  to  the  com- 
pany their  skill  and  experience.  Surely  a  company  so  organ- 
ized has  a  bright  future.  And  notice  how  certain  are  its 
dividends.  Here  is  a  statement  made  by  responsible  author- 
ity that  the  earnings,  increased  by  the  elimination  of  com- 
petition, would  be  sufficient  to  pay  interest,  preferred  divi- 
dends, and  ten  per  cent  on  the  common  stock  "while 
indications  fully  sustain  the  belief  that  they  will  be  even 
higher  in  the  future." 

The  official  statement  often  descends  to  circumstantial 
details  of  prophecy.  Witness  the  savings  which  the  Interna- 
tional Silver  Company  was  expected  to  realize: 

SAVINGS  BY  CONSOLIDATION 

Present  Expenses    Reduced  to 

Salesrooms  and  clerk  hire $375,000  $100,000 

Travelers'  salaries 350,000  125,000 

Travelers'  expenses 400,000  75,000 

Clerk  hire,  etc 275,000  50,000 

Designers,  machinists,  etc 225,000  75,000 

Advertising 200,000  50,000 

$1,825,000         $475,000 
475,000 

Total  saving $1,350,000 

PAYMENTS 

Present  Expenses  Receipts 

6  per  cent  interest  on  $3,500,000  bonds .      $210,000  $1,350,000  ^ 

7  per  cent  dividend  on  $4,500,000  pre- 

ferred         315,000  526,000 ' 

10  per  cent  dividend  on  $10,000,000  com- 
mon       1,000,000 

$1,525,000  $1,876,000 « 

1,525,000 

•       $351,000  * 

*  Savings.  2  Previous  earnings  before  consolidation. 

'  Total  profits.  *  Surplus. 


SALE    OF   SPECULATIVE   SECURITIES        147 

.  These  samples  are  typical  of  the  entire  list.  In  the  major- 
ity of  oflScial  statements,  it  was  claimed  that  the  earnings 
of  the  constituent  companies  before  consolidation  were  suf- 
ficient to  pay  dividends  on  the  preferred  stock,  and  that  the 
common  stock  represented  the  capitalized  value  of  the  econ- 
omies of  combination.  All  the  savings  from  management, 
shipping,  buying  and  selling,  and  all  the  increased  profits 
of  monopoly  were  to  go  to  the  common  stock,  which  was 
therefore  assured  of  large  dividends. 

And  yet,  in  spite  of  these  detailed  and  apparently  author- 
itative statements  of  profits,  there  was  no  real  difference 
between  the  argument  of  the  syndicate  manager  of  the  trust 
and  that  of  the  oil  or  town-site  "  boomer."  The  first  was 
more  dignified,  that  is  all.  The  method  of  the  appeal  and 
the  class  to  whom  the  appeal  was  made  are  the  same  in 
the  case  of  either  proposition.  For,  notice  what  the  syndi- 
cate manager  offered.  These  common  stocks,  which  were 
certain  of  such  large  dividends,  were  freely  offered  at  such 
low  prices  as  to  stamp  them  at  the  outset  with  the  bar 
sinister.  The  average  prices  of  various  common  stocks  dur- 
ing the  first  month  of  their  listing  on  the  exchange  were 
as  follows: 


American  Car  and  Foundry 20% 

American  Ice 39^ 

American  Malting 273^ 

American  Smelting  and  Refining  ,54^ 

American  Steel  Hoop 39!^ 

American  Steel  and  Wire 401^ 

American  Tin  Plate 40^ 


Continental  Tobacco ....  53^ 

Federal  Steel Sl}4 

International  Paper 57i/^ 

International  Silver SSj/g 

National  Biscuit 33% 

National  Steel 523^ 

Republic  Iron  and  Steel. .  .25>i6 


These  prices,  when  measured  by  the  yield  on  safe  invest- 
ments, represented  extravagant  returns.  Take,  for  example, 
two  of  the  trusts  above  mentioned — International  Paper  and 
International  Silver — both  professing  ability  to  pay  ten  per 
cent  on  their  common  stocks.  With  International  Paper, 
the  offering  price — that  is  to  say,  the  price  at  which  the 
stock  should  have  been  purchased  during  the  first  month 
of  listing — represented  a  yield  on  the  investment,  granted 


148  CORPOKATION  FINANCE 

that  the  representations  of  the  promoters  were  correct,  of 
17.2  per  cent,  while  the  common  stock  of  International 
Silver,  selling  around  32  represented  a  return  of  31.2  per 
cent  on  its  purchase  at  that  price.  Nearly  every  trust 
prospectus  contained,  however,  adroitly  worded,  an  express 
or  implied  promise  of  dividends  on  the  common  stock,  and 
any  dividends  on  the  common  stock  at  the  prices  at  which 
it  was  offered  on  the  exchanges  meant  an  enormous  rate 
of  return. 

With  the  preferred  stocks  it  was  a  little  better.  These 
stocks  had  actual  earning  power  back  of  them,  while  the 
common  stocks  had  only  prospective  earning  power.  The 
preferred  stocks  of  the  trust  were  generally  offered  around 
76-80  which,  at  the  usual  dividend  rate  of  seven  per  cent 
yielded  8.7  per  cent  on  their  purchase,  a  yield  too  large  for 
the  investor  and  indicating  an  inferior  class  of  buyers.  Even 
the  best  of  the  preferred  stocks  could  not  claim  to  rank  as 
safe  investments,  although  they  had  a  certain  amount  of 
reality  to  sustain  their  value. 

As  for  the  common  stock,  however,  what  was  the  differ- 
ence between  selling  a  man  oil  stock  or  mining  stock  of 
fifty  cents  par  value  at  five  cents  per  share  on  the  prospect 
that  a  gusher  or  a  bonanza  will  be  struck  and  the  stock  go 
to  par  or  above,  and  selling  him  paper,  or  steel,  or  tobacco 
at  35  or  40  or  50  for  a  $100  share  on  the  prospect  that  all 
the  expectations  of  the  promoter  will  be  realized,  and  the 
stock  go  to  par  on  the  certainty  of  large  dividends?  Both 
were  speculative  propositions.  Both  are  based  on  unknown 
conditions.  Neither  had  any  positive  assurance  to  rest  upon. 
In  the  one  case  the  mine  "  ought "  to  be  rich,  and  in  the 
other  the  earnings  of  the  trust  "  are  expected  "  to  be  large. 
The  mine  boomer  points  to  the  growing  demand  for  copper, 
and  the  trust  boomer  talks  about  the  "  marvelous  prosperity 
of  the  country."  The  one  had  his  calculations  of  cost  and 
profit  and  his  township  and  section  maps;  the  other  his 
expert  accountants'  reports,  his  "beliefs,''  "expectations," 
and  "estimates"  of  the  savings  by  consolidation  and  his 


SALE   OF   SPECULATIVE   SECURITIES        149 

imposing  list  of  properties,  sometimes  covering  the  entire 
country.  With  the  mining  company,  it  is  the  judge,  the 
merchant,  and  the  mining  expert  who  give  weight  to  the 
proposition.  With  the  trust,  it'  was  the  great  bankers  and 
manufacturers  who  lent  their  influence  to  insure  the  suc- 
cess of  the  flotation.  At  all  points,  the  similarity  between 
the  two  propositions  is  complete.  The  trust  stocks  could  not 
be  sold  to  the  investor.  The  speculator  would  buy  them 
only  on  the  prospect  of  a  rate  of  return  so  large  as  to  prove 
that  the  success  of  the  trust  was  at  the  best  problematical. 

On  its  face,  however,  the  proposition  offered  by  the  com- 
mon stock  was  certainly  attractive.  The  syndicate  manager 
would  sell  a  stock  at  40  or  50,  which  must  pay  at  least  six 
or  even  ten  per  cent  on  its  par  value.  The  common  stock 
was  the  residual  claimant.  The  preferred  stockholder,  it  is 
claimed,  is  not  better  off  than  before ;  but  the  common  stock- 
holder was  to  reap  the  full  fruition  of  the  great  step  in 
industrial  progress  which  the  formation  of  the  trust  repre- 
sented. Here  was  offered  a  double  inducement;  a  high  rate 
of  dividend  if  the  stock  was  held,  or  an  opportunity  to  sell 
at  an  advance. 

Moreover,  the  syndicate  manager  need  not  rely  solely 
upon  published  statements.  Competent  and  authoritative 
opinion  was  not  lacking  to  influence  the  wavering  and  uncer- 
tain speculator.  The  underwriting  privileges  had  been  sold 
as  Judge  Moore  expressed  it,  "  all  over  the  country."  Finan- 
cial houses  and  moneyed  men  everywhere  had  been  let  in 
for  a  share  of  the  underwriting  and  had  stock  to  sell.  Be- 
sides this,  there  were  a  large  number  of  manufacturers  in 
all  the  industrial  centers  who  wished  to  realize  on  their  stock. 
These  institutions  and  individuals  have  a  large  following, 
and  their  opinions  upon  financial  matters  are  held  to  be  very 
weighty.  The  promoters  of  American  asphalt,  for  example, 
had  a  long  record  of  success  in  gas  and  electric  railway  en- 
terprises behind  them,  and  their  following  in  Philadelphia 
was  enormous.  A  proposition  which  had  their  indorsement 
was  by  most  people  considered  worth  looking  into.  The 
11 


150  COKPOKATION   FINANCE 

influence  which  could  be  exerted  in  this  way  in  favor  of 
the  new  securities  was  powerful. 

There  need  be  no  direct  solicitation.  That  would  be 
undignified,  and  might  mal^e  trouble  between  •  friends  if 
anything  went  wrong.  More  than  this,  direct  solicita- 
tion was  unnecessary.  As  Bacon  remarks  in  his  essay  on 
Cunning :  "  It  works  better  when  anything  seemeth  to  be 
gotten  from  you  by  question  than  if  you  offer  it  of  your- 
self." This  advice  to  buy  speculative  stock  is  almost  al- 
ways "gotten  by  question"  and  is  disinterestedly  given. 
The  news  of  the  formation  of  the  trusts  is  in  everybody's 
mouth.  Their  prospectuses  are  in  the  newspapers.  Imag- 
ination magnifies  their  really  enormous  extent  and  power 
and  the  profits  which  they  will  realize.  Their  stock  is 
now  offered  to  the  public  at  a  low  price.  What  more  nat- 
ural than  to  consult  with  one's  financial  adviser,  and  what 
so  conservative  as  his  opinion?  He  advised  no  one  to  buy, 
or  if  he  ventured  so  far,  it  is  always  with  the  caution  that 
"  something  may  go  wrong,  that  bit  of  caution  which  estab- 
lishes him  firmly  as  a  safe  adviser.  He  lets  it  be  under- 
stood that  he  thinks  well  of  the  proposition,  that  he  is  per- 
sonally interested  in  it,  and  he  merely  suggests  that  it  is 
"  worth  investigating."  In  such  matters,  he  who  investigates 
is  lost.  The  advice  is  often  taken  and  the  stock  sold.  The 
underwriters  and  owners  had  only  to  let  it  be  known  that 
they  considered  the  trust  stock  a  good  thing,  to  gather  in 
a  large  amount  of  money  from  the  speculators. 

There  is  another  class  to  whom  stock  can  be  sold.  These 
are  the  margin  speculators,  the  people  who  buy  stocks  not 
to  hold  but  to  sell,  whose  object  is  not  income  but  increased 
capital.  By  depositing  a  small  per  cent,  say  ten  per  cent, 
of  the  market  value  of  any  security  with  a  broker,  he  will 
borrow  the  remainder  of  the  money  and  buy  stock  for  them, 
loaning  them  the  difference  between  their  deposit  and  the 
value  of  the  stock,  and  holding  the  stock  in  his  vault.  His 
customers  pay  him  interest  on  the  money  borrowed  to  buy 
the   stock,  usually  a  higher  interest  than  he  himself  pays 


SALE   OF   SPECULATIVE   SECURITIES        151 

to  the  bank,  and  in  addition  a  one  eighth  per  cent  commis- 
sion on  the  par  value  of  the  shares. 

The  broker  will  buy  or  sell  the  stock  as  his  customers 
may  direct.  By  depositing  $100  and  paying  $12.50  com- 
mission and  six  per  cent  interest  on  $900  the  amount  bor- 
rowed for  him  by  the  broker  for  the  time  he  holds  the  stock 
— the  speculator  can  become  the  owner  of  twenty  shares  of 
stock  which  is  selling  around  50.  Suppose  the  stock  goes 
up  ten  points,  he  may  sell  and  double  his  money,  less  the 
commission  and  interest.  If  the  stock  declines,  however,  the 
broker  takes  the  loss  out  of  his  margin,  and  if  the  decline 
is  excessive  the  trader  may  be  called  on  for  more  margin, 
failing  to  produce  which  the  broker  sells  the  stock  and  re- 
pays the  loan  incurred  to  buy  it,  crediting  the  speculator 
with  any  of  the  margin  which  may  remain.  Any  dividends 
which  may  be  paid  on  the  stock  during  the  time  it  is  being 
carried  are  credited  to  the  buyer.  It  is  this  fact  that  dis- 
tinguishes gambling  with  chips  or  cards  from  gambling  with 
stocks.  In  the  first  case  the  gambling  instrument  is  un- 
productive. The  "  rake-off "  of  the  house  is  clear  loss  to 
the  players.  With  stocks,  however,  the  "  rake-off  "  is  offset 
by  the  dividends.  The  gambling  implements  are  themselves 
productive. 

The  speculator  may  also  purchase  an  option  to  deliver 
stock  in  the  future  at  the  price  now  ruling.  In  this  case, 
the  broker  borrows  the  stock  or  loans  it  out  of  his  own  office 
and  makes  the  delivery  within  twenty-four  hours  for  his 
customer.  In  case  the  stock  is  borrowed  from  another  office, 
the  borrowing  broker  deposits  as  security  with  the  lender 
a  sum  of  money  equal  to  the  market  value  of  the  stock  on 
the  day  of  the  loan,  and  for  this  money  he  receives  a  rate 
of  interest,  called  the  "loan  rate"  on  stocks,  which  offsets 
his  customer's  interest  and  makes  short  selling  cheaper  than 
buying.  The  broker  is  protected  by  the  usual  margin  against 
an  advance  in  the  price  of  the  stock.  If  the  price  declines 
from  100  to  95  the  short  seller  of  100  shares  orders  his 
broker  to  buy  for  $9,500  the  stock  against  which  $10,000 


152  CORPORATION   FINANCE 

has  been  deposited.  The  broker  then  delivers  the  stock  to 
the  one  who  has  loaned  it  to  him,  and  receives  back  his 
$10,000,  placing  $500  to  his  customer's  account  and  return- 
ing to  him,  if  he  desires  it,  his  original  margin  of  $1,000, 
plus  the  net  profits.  If  the  stock  advances,  however,  the 
short  seller  may  be  called  on  to  protect  his  margin,  for  if 
the  price  has  risen  from  100  to  105,  $10,500  will  be  neces- 
sary to  buy  the  stock  with  which  to  take  up  the  loan  and 
receive  back  the  $10,000  deposited  as  security.  In  this  case, 
the  customer  has  lost  half  his  margin. 

This  form  of  gambling  is  very  attractive.  It  is  so  much 
like  "business,"  so  much  apparently  depends  on  the  judg- 
ment of  the  buyer  and  so  little  on  the  turn  of  the  wheel  or 
the  chance  of  the  draw.  The  speculator's  pulses  quicken  and 
slow  with  the  good  or  bad  fortune  of  the  nation.  He  is 
interested  in  the  crops,  in  the  railroad  earnings,  in  national 
elections,  and  in  foreign  wars.  His  profits  depend  apparently 
upon  his  own  judgment.  He  is  as  confident  of  winning  as 
the  gambler  with  a  "  system  "  is  confident  of  breaking  the 
bank.  Moreover,  speculation  is  respectable.  It  is  not  by  all 
persons  considered  reputable  to  play  the  races;  but  it  is  not 
often  that  one  loses  caste  by  playing  the  stock  market.  Every 
class  of  the  population  is  represented  among  the  margin 
speculators.  Business  men  and  professional  men  are  found 
in  the  better  offices;  clerks,  teachers,  ministers  and  women 
frequent  the  intermediate  grades  and  the  bucket  shops. 

The  promoter  may  reckon  with  this  class.  It  is  to  his 
interest  to  impress  them  with  the  favorable  outlook  for  his 
enterprise  in  order  to  persuade  them  to  buy  for  a  rise.  The 
outside  buyer  is  almost  always  a  bull.  The  margin  specu- 
lator does  not  want  the  stock  and  is  apt  to  sell  on  an  advance. 
He  puts  his  money  into  margins  in  the  belief  that  the  stock 
will  rise  in  value.  The  more  seductive  the  representations 
of  the  promoters,  enforced  as  they  are  by  the  "  tips "  and 
the  market  letters  of  the  brokers,  the  larger  will  be  the 
buying.  As  the  stock  goes  up,  the  profits  realized  are  turned 
back  into  new  margins  and  the  advance  gathers  strength  as 


SALE   OF   SPECULATIVE   SECUKITIES        153 

it  proceeds.  Indeed,  it  often  happens  that  the  value  of  a 
speculative  stock  may  be  carried  high  above  its  investment 
value  as  indicated  by  the  earnings  of  the  company.  The 
buyer  for  investment  is,  however,  the  half  seen  goal  of  the 
speculator.  The  investment  demand  always  looms  ahead, 
and  the  speculator  deposits  his  margins  in  the  belief  that  the 
market  value  is  still  below  the  investment  value. 

A  stock  whose  value  is  highly  uncertain,  fluctuating  with- 
in wide  and  irregular  limits,  affected  by  every  breeze  of 
rumor,  such  a  stock  as  Reading  common  or  United  States 
Steel  common,  for  example,  is  also  a  favorite  with  the 
speculators.  It  is  so  attractively  uncertain,  and  there  is 
always  the  chance  that  when  it  falls  it  will  rise  again.  The 
trust  stocks  have  all  been  of  fluctuating  value  and  so  have 
been  popular  with  the  margin  speculators.  The  inducement 
to  engage  in  these  operations  is  the  national  desire  to  get 
something  for  nothing,  or  rather  much  for  little.  Stories 
of  successful  operation  are  widely  heralded,  and  losses  are 
generally  kept  secret.  Stories  of  large  profits,  like  the  ad- 
vertisements of  the  Louisiana  lottery,  point  the  way  to  a 
desirable  addition  to  a  limited  income.  The  psychology  of 
gambling,  however,  is  a  study  by  itself  and  need  no  longer 
detain  us. 

In  what  way  does  this  gambling  furnish  capital  to  the 
new  enterprises?  Their  securities  are  wanted  for  speculative 
material  by  the  brokers.  They  are  the  "  chips  "  with  which 
the  public  play  the  great  game  of  speculation.  The  opera- 
tion is  something  as  follows :  The  surplus  cash  of  the  country 
is  sent  to  New  York  City.  This  money  can  be  recalled  at 
any  time,  and  the  greater  part  of  it  is,  therefore,  not  avail- 
able for  time  loans.  It  may,  however,  be  loaned  on  call. 
The  brokers  borrow  this  money  and  buy  stocks  for  their 
customers.  They  also  borrow  large  sums  on  time  loans  to 
carry  their  larger  clients.  So  far  as  the  promoter  and  under- 
writer are  concerned,  it  is  the  same  thing  as  though  the 
broker  was  an  investor.  Their  only  object  is  to  make  the 
enterprise  as  attractive  as  possible  to  the  public,,  so  that  the 


154  COEPORATION   FINANCE 

demand  for  speculative  material  may  be  large.  The  brokers, 
on  their  part,  use  the  stocks  for  collateral  at  the  banks,  mix- 
ing it  with  other  securities  to  support  its  wavering  value, 
and  make  up  the  difference  between  the  market  price  and  the 
value  which  the  bank  puts  on  the  stock  as  collateral — often 
about  twenty  points  below  the  market — by  their  own  funds 
and  the  margins  which  they  require  from  their  customers. 
Thus  a  large  part  of  the  surplus  funds  of  the  country  is 
turned  over  to  the  founders  of  new  enterprises  through  the 
channels  of  speculation.  The  money  which  the  syndicate 
managers  receive  for  their  stock  is  borrowed  money,  but  that 
makes  no  difference  to  them;  they  do  not  borrow  it.  The 
larger  the  demand  for  their  stocks  from  margin  speculators, 
the  larger  is  the  amount  of  money  which  is  borrowed  by  the 
brokers  and  turned  over  to  the  S3Tidicate. 

The  amount  of  this  demand  is  very  large.  On  September 
7,  1899,  the  demand  loans  of  the  national  banks  of  New 
York  City  amounted  to  $228,081,518.  A  large  part  of  this 
money  was  loaned  to  speculators,  and  much  of  it  on  indus- 
trials. This  money  was  turned  over  and  over,  and  constantly 
replenished  by  new  margins  so  that  it  might  pass  more  than 
one  in  original  exchange  for  stocks.  The  total  number  of 
shares  sold  on  the  New  York  Stock  Exchange  in  1899,  a  year 
of  most  active  speculation  in  industrials,  was  176,421,135, 
although  the  total  number  listed  did  not  exceed  60,000,000. 
On  the  basis  of  these  figures,  each  stock  was  sold  three  times 
over. 

Speculation  in  high-priced  stocks  is  too  expensive  for 
the  average  trader.  A  share  selling  for  300  would  require 
$30  margin.  Three  thousand  dollars  are  necessary  to  pur- 
chase 100  shares.  A  ten  point  rise  in  this  stock  means  only 
$1,000  profit.  But  for  $3,000  the  speculator  can  purchase 
600  shares  of  an  industrial  selling  around  50,  and  a  five 
point  rise  in  such  a  stock  means  $3,000  profit.  The  lower 
the  price  of  the  stock,  the  larger  is  the  number  of  shares 
which  $1,000  invested  in  margins  will  control,  and  the  larger 
is  the  possible  profit  from  fluctuations.     On  the  other  hand, 


SALE   OF   SPECULATIVE   SECURITIES        155 

with  the  high-priced  stock,  the  risk  of  loss  from  fluctuations, 
contrary  to  the  buyer's  expectation,  is  as  great  as  with  low- 
priced  stocks.  It  was  inevitable  that  the  general  advance  in 
railway  securities  should  transfer  the  speculative  interest  to 
low-priced  industrials. 

The  Wall  Street  Journal^  in  an  editorial  of  March  3, 
1901,  expressed  this  conclusion  as  to  the  speculative  value  of 
industrial  shares :  "  It  is  as  certain  as  anything  in  the  future 
that  industrial  securities  will  form  the  principal  medium  for 
speculation  in  this  country.  The  field  for  the  formation  of 
industrial  corporations  is  vast,  and  varying  degrees  of  skill 
in  management  coupled  with  the  succession  of  good  times 
and  bad  times,  will  make  constant  changes  in  values  which 
will  be  discounted  by  movements  in  the  prices  of  stocks." 

The  syndicate  manager  counted  upon  this  speculative 
demand.  It  is  his  principal  resort  during  the  early  stages 
of  the  flotation.  He  advertises  his  stock  in  no  way  so  effec- 
tively as  by  the  record  of  the  ticker  tape.  By  "  wash  sales  " 
— i.  e.,  sales  immediately  covered  by  purchases  between  brok- 
ers acting  for  the  same  interest — he  creates  an  excitement 
on  the  curb.  The  stock  begins  to  attract  attention.  The 
newspapers  take  it  up.  This  or  that  report  is  given  currency : 
"  Interests  that  know  something  about  steel  are  buying" ; 
"  The  earnings  of  International  Paper  are  reported  by  high 
authority  to  be  exceedingly  expectations " ;  "  Something  is 
likely  to  be  doing  soon  in  Eubber  common." 

More  considerable  articles  help  these  stray  notes.  The 
reader  of  the  financial  column  is  told  that  "  the  dividends 
of  the  industrial  stocks  during  the  past  six  or  seven  years 
have  been  remarkable  in  amount,  and  the  more  remarkable 
in  that  these  years  have  been  those  of  extended  commercial 
depression.  Now  if  these  various  companies  have  been  able 
to  pay  good  dividends  through  times  so  unprosperous  com- 
mercially, the  prospect  is  that  they  will  continue  and  increase 
them  in  the  years  before  us,  when  the  soundest  financiers 
have  predicted  an  era  of  industrial  and  commercial  ex- 
pansion such  as  this  country  has  not  witnessed  for  a  genera- 


156  COKPORATION   FINANCE 

tion,"  etc.,  etc.     Every  day  the  papers  are  full  of  such  ma- 
terial. 

Leading  operators  come  out  boldly  and  indorse  the  stock. 
It  is  admitted  to  the  Exchange.  Dealings  rapidly  increase, 
and  a  broad  market  is  established  by  a  steady  advance.  The 
higher  the  stock  climbs,  the  more  eager  are  the  speculators 
to  purchase.  If  the  syndicate  manager  catches  the  flood 
tide  of  a  bull  market,  he  may  dispose  of  his  entire  holdings, 
as  the  syndicate  managers  of  the  Steel  Trust  would  probably 
have  done  had  not  the  panic  of  May  9,  1901  interfered. 
The  New  York  Stock  Exchange  is  the  place  where  large 
flotations  can  be  most  quickly  made.  It  is  here  that  the 
speculative  interest  of  the  country  centers.  The  mining 
boomer  peddles  his  stock  about  the  street  and  advertises  it 
in  the  newspapers.  He  is  a  retailer  of  securities.  If  he 
realizes  $50,000  from  the  public,  he  may  consider  himself 
exceptionally  fortunate.  The  syndicate  manager  places  his 
interest  in  charge  of  an  expert  manipulator,  a  wholesaler — 
who  may  "  clean  up  "  several  millions  in  a  few  months. 


CHAPTEE   XIII 
UNDERWRITING 

Nearly  all  public  flotations  require  the  aid  of  the  un- 
derwriter. The  underwriter,  as  his  name  implies,  insures  or 
guarantees  the  sale  of  securities  within  a  certain  time  at  a 
price  sufficiently  below  the  anticipated  market  price  to  insure 
a  profit  to  the  guarantor.  It  is  a  matter  of  indifference  to 
the  corporation  whether  its  securities  are  sold  outright  or 
whether  a  responsible  syndicate  guarantees  the  sale.  In  either 
case,  the  money  necessary  is  provided  at  once  by  the  bankers, 
who  must  look  to  the  sale  of  the  securities  which  they  have 
underwritten  or  purchased,  for  their  reimbursement. 

In  underwriting  the  securities  of  a  new  company,  or  in 
purchasing  them  outright,  the  banker  who  undertakes  the 
responsibility  of  the  transaction  usually  associates  with  him- 
gelf  a  number  of  other  individuals  and  banking  houses  in  an 
organization  known  as  an  underwriting  or  subscription  syn- 
dicate. The  difference  between  underwriting  and  subscrip- 
tion is  that  in  underwriting  the  securities  underwritten  by 
the  banker  are  offered  for  sale  by  the  corporation  through 
the  banker,  and  in  subscription,  the  securities  are  purchased 
by  the  banker  and  offered  by  him  to  his  own  customers  as 
sound  investments.  In  either  case,  the  association  which  is 
formed  to  assist  him  in  carrying  out  his  contract  with  the 
corporation  is  substantially  identical,  and  the  two  forms  of 
syndicate  underwriting  and  subscription  can  be  considered 
together. 

The  underwriting  syndicate  is  a  voluntary  and  temporary 
association  of  individuals  or  firms  or  corporations  which  is 

157 


158  COEPOKATION   FINANCE 

formed  by  a  sj^dicate  manager,  usually  a  banking  firm,  to 
assist  them  in  guaranteeing  the  sale  of,  or  in  purchasing  an 
issue  of  stocks  or  bonds.  The  steps  in  the  organization  of 
the  syndicate  are  as  follows : 

The  original  contract  is  made  between  the  banker  and 
the  corporation,  by  which  the  banker  agrees  to  either  pur- 
chase certain  securities  at  a  price,  or  to  guarantee  their  sale 
within  a  certain  time,  at  a  certain  price.  The  corporation 
usually  knows  no  one  but  the  syndicate  manager  in  the  trans- 
action, and  looks  only  to  him  for  the  fulfillment  of  the*  agree- 
ment. The  fact  that  the  banker  associates  others  with  him- 
self in  the  transaction,  in  an  underwriting  syndicate,  is  a 
matter  of  no  concern  to  the  corporation,  although  the  mem- 
bers of  the  syndicate  may  be  asked,  with  the  consent  of  the 
corporation,  to  directly  assume  a  share  of  the  syndicate  man- 
ager's liabilities. 

While  the  syndicate  manager  may  be  a  very  strong  bank- 
ing firm,  such  as  J.  P.  Morgan  &  Company;  Kuhn,  Loeb  & 
Company,  and  may  be  able  to  guarantee  the  flotation  of  a 
very  large  issue  of  securities,  it  is  usually  advantageous  to 
organize  a  syndicate.  Most  banking  houses  have  a  definite 
policy  which  regulates  the  amount  of  capital  which  they  will 
allot  to  a  particular  enterprise.  The  house,  for  example, 
with  a  capital  of  $10,000,000  may  have  a  rule  that  it  will 
not  invest  more  than  $1,000,000  in  any  one  undertaking,  so 
that  any  losses  which  it  may  sustain  by  unsuccessful  invest- 
ments may  be  offset  by  the  profits  of  those  which  have  been 
profitable.  When,  therefore,  this  banking  house  makes  an 
agreement  to  underwrite  $10,000,000  of  bonds  or  preferred 
stock,  unless  it  departs  from  its  established  policy  of  dividing 
its  risks,  it  must  add  to  its  capital  the  capital  of  its  friends. 

By  admitting  other  bankers  with  wide  connections  and 
large  numbers  of  clients  to  share  in  the  profits  of  its  sub- 
scription, a  banking  house  obtains  a  broad  market  for  the 
securities  which  it  has  for  sale  and  by  adopting  this  policy 
in  all  its  undertakings  it  makes  sure  of  quicker  returns. 
The  necessity  of  securing  a  broad  market  for  bonds  or  stocks 


UNDEEWKITING  159 

is  sometimes  recognized  in  the  original  contract  between  the 
corporation  and  the  bankers  by  a  joint  agreement  between 
several  banking  houses  so  situated  as  to  command  invest- 
ment funds  in  different  parts  of  the  country.  A  recent  bond 
issue  of  the  American  Telephone  Company,  for  example,  was 
taken  by  J.  P.  Morgan  &  Company ;  Kuhn,  Loeb  &  Company ; 
Kidder,  Peabody  &  Company,  of  New  York,  and  Baring 
Brothers,  of  London.  Ordinarily,  the  subscription  would 
have  been  offered  to  a  New  England  banking  house,  but  the 
New  England  market  was  unable  to  absorb  more  telephone 
securities  and  a  broader  market  was  required,  fo  obtain  which 
the  cooperation  of  New  York  and  London  houses  was  enlisted. 
An  Eastern  house,  undertaking  the  underwriting  or  pur- 
chase of  bonds  of  a  Western  enterprise,  associates  with  itself, 
if  possible.  Western  bankers  whose  clients  are  likely  to  be 
familiar  with  the  enterprise.  The  syndicate  is  organized  as  fol- 
lows :  A  contract  is  made  between  the  Pennsylvania  Railroad 
Company  and  Speyer  &  Company.  The  head  of  the  banking 
house  communicates  with  a  number  of  firms  and  individuals 
with  whom  they  have  cooperated  in  the  past.  If,  as  in  the 
case  cited,  Speyer  &  Company  have  agreed  to  guarantee  the 
sale  of  $75,000,000  of  stock  of  the  Pennsylvania  Railroad 
Company  at  120  in  return  for  a  commission  of  $2,250,000, 
they  will  recite  these  facts  in  their  communications  to  those 
whom  they  wish  to  join  in  the  syndicate,  and  they  will  ask 
each  one  to  indicate  by  return  mail  or  telegraph,  the  amount 
of  participation  in  the  syndicate,  which  Speyer  &  Company 
state  they  propose  to  form,  which  he  desires.  One  house 
will  ask  for  $1,000,000,  another  house  for  $5,000,000,  an- 
other house  for  $500,000,  and  so  on.  Very  few  will  decline 
because,  to  refuse  to  participate  in  a  syndicate  when  re- 
quested by  a  house  of  the  standing  of  Speyer  &  Company, 
may  result  in  excluding  the  banker  from  participation  in 
any  new  syndicate,  and  may  also  cost  him  the  cooperation 
of  Speyer  &  Company  in  his  own  undertakings.  After  the 
replies  have  all  been  received,  the  amounts  are  summed  up 
and  either  one  of  two  results  may  be  disclosed.    The  applica- 


160  COKPORATION   FINANCE 

tions  for  participation  in  the  syndicate  may  exceed  the 
amount  of  securities  which  have  been  underwritten  or  pur- 
chased, and  they  may  be  below  the  required  amount.  In  the 
second  place,  unless  the  deficiency  is  considerable,  the  plans 
of  the  syndicate  manager  are  not  disarranged,  since  he  ex- 
pected to  take  a  certain  amount  of  participation  in  the 
syndicate  himself.  It  may  also  be  necessary,  in  case  his 
request  for  applications  does  not  meet  with  a  cordial  response, 
for  him  to  assume  a  much  larger  part  of  the  responsibility 
than  he  originally  intended.  For  the  most  part,  however, 
this  contingency  is  guarded  against  by  offering  participations 
in  the  syndicate  to  such  a  large  number  of  important  houses 
and  financiers  as  to  make  it  unlikely  that  the  combined  sub- 
scriptions will  be  below  the  amount  which  the  syndicate 
manager  considers  necessary.  In  most  cases  the  amount 
will  be  largely  oversubscribed.  He  may  require  only  $75,- 
000,000,  and  the  sum  of  his  applications  to  participate  in 
the  syndicate  may  be  $150,000,000. 

It  is  now  necessary  for  the  S5mdicate  manager  to  allot 
these  subscriptions.  Since  this  is  an  association  somewhat 
resembling  the  corporation,  in  which  the  liability  of  the  par- 
ticipants is  limited  to  the  amounts  of  their  subscriptions,  it 
might  be  supposed  that  everyone  would  stand  on  the  same 
footing,  just  as  when  subscriptions  to  the  stock  of  a  corpo- 
ration are  made.  In  this  case,  if  the  subscriptions  are  twice 
the  amount  necessary,  each  subscriber  will  expect  to  receive 
one  half  of  the  amount  subscribed  for. 

With  the  underwriting  or  subscription  syndicate,  how- 
ever, the  procedure  is  different.  This  voluntary  association 
or  temporary  corporation,  which  is  in  process  of  organization 
by  the  syndicate  manager,  is  for  his  individual  benefit.  It 
is  a  business  enterprise  which  he  is  promoting.  While  he 
requires  the  members  of  his  syndicate  to  indicate  how  much 
of  a  participation  they  desire,  he  does  not  guarantee  to  give 
them  all  they  ask  for.  He  makes  his  allotment  according  to 
his  understanding  of  his  own  advantage,  and  he  considers 
nothing  but  his  own  interest,  and  the  interest  of  the  corpora- 


UNDEKWRITING  161 

tion  for  whose  financial  affairs  he  is  temporarily  responsible. 
He  may  assign  one  applicant  100  per  cent  of  his  application, 
another  fifty  per  cent,  another  ten  per  cent,  and  another  five 
per  cent.  No  member  of  the  syndicate  is  likely  to  be  in- 
formed by  the  syndicate  manager,  although  he  may  easily 
learn  from  members  direct,  how  much  allotment  another 
member  has  received. 

The  principles  which  govern  this  allotment,  looking  at 
it  from  the  standpoint  of  the  syndicate  manager,  are  as  fol- 
lows :  In  the  first  place,  he  wishes  the  flotation  to  be  a  success, 
and  he  makes  his  allotment  with  tliis  object  principally  in 
view.  A  particular  kind  of  securities  will,  in' his  judgment, 
find  a  ready  market  in  Cleveland.  He  will  allot  the  full 
amount  of  their  applications  to  Cleveland  bankers.  If  a  flota- 
tion of  a  similar  character  has  failed  in  Baltimore,  Balti- 
more bankers  will  have  to  be  content  with  a  small  share  of 
their  applications. 

On  the  other  hand,  individual  financiers  who  were  not 
able  to  assist  in  marketing  the  bonds,  or  applicants  for 
small  amounts  may  receive  only  small  percentages  of  allot- 
ment. The  syndicate  manager  expects  to  be  in  business  for 
many  years;  he  wishes  to  participate  in  underwriting  syndi- 
cates managed  by  other  bankers.  WTien  he  receives  an 
application  from  a  banker  who  is  himself  a  manager  of  syn- 
dicates, he  will  give  that  banker  what  he  asks  for,  since  other- 
wise he  might  himself  be  cut  off  from  some  profitable  par- 
ticipation in  the  future.  Participations  in  syndicates,  in 
other  words,  are  allotted  for  the  sake  of  securing  participa- 
tions in  other  syndicates.  A  banker  makes  his  allotments  to 
cultivate  business  good-will  with  the  banks  and  trust  com- 
panies from  which  he  may  wish  to  borrow  money,  and  in 
every  way  possible  to  strengthen  his  position  and  influence 
by  the  disposition  of  the  allotments  which  are  entirely  in  his 
hands. 

After  the  syndicate  manager  has  decided  upon  the  allot- 
ments, he  sends  to  each  subscriber  a  copy  -of  the  syndicate 
agreement  which  the  subscriber  signs,  and  opposite  to  his 


162  CORPOKATION   FINANCE 

name  places  the  amount  of  his  allotment.  The  subscriber  is 
then  bound  by  the  conditions  of  the  agreement,  up  to,  but 
no  further  than  the  amount  for  which  he  has  subscribed. 
Provisions  usually  found  in  underwriting  agreements  are  as 
follows : 

First,  the  subscriber  agrees  to  take  and  pay  for  the  amount 
of  securities  for  which  he  has  subscribed  when  called  upon  by 
the  syndicate  manager,  and  this  agreement  may  be  enforced 
against  him  in  the  usual  manner  by  a  suit  at  law. 

Second,  he  agrees  that  the  syndicate  manager  shall  have 
entire  charge  of  the  marketing  of  the  bonds  or  stock,  that 
he  rnay  make  any  and  all  contracts  and  incur  any  expenses 
necessary  to  secure  their  sale,  and  that  all  these  charges  and 
expenses  shall  be  a  first  claim  upon  the  profits  of  the  syn- 
dicate. An  illustration  of  the  large  discretion  given  to  the 
syndicate  manager  is  taken  from  the  agreement  between 
Speyer  &  Company  and  the  members  of  the  syndicate  which 
underwrote  the  $75,000,000  stock  issue  of  the  Pennsylvania. 
This  agreement  provided  in  part  as  follows: 

The  managers  may  from  time  to  time  in  their  dis- 
cretion purchase  upon  the  markets  shares  of  stock  of 
the  railroad,  or  rights  to  subscribe  for  stock,  and  in 
case  of  any  such  purchases  the  syndicate  obligation 
shall  be  increased  by  the  amount  thereof,  and  the 
obligation  of  each  subscriber  shall  be  increased  pro- 
portionately, provided,  however,  that  the  aggregate 
syndicate  obligation  shall  not  at  any  time  be  increased 
by  such  purchases  by  an  amount  exceeding  ten  per 
cent  of  the  aggregate  subscription  price  of  the  stock 
offered  to  the  stockholders. 

The  syndicate  subscribers  appoint  the  syndicate 
managers  their  agents  and  attorneys,  with  full  power 
to  do  any  and  all  acts  expedient  to  perform  the  agree- 
ment, including  the  repurchase  and  resale  from  time 
to  time  for  the  account  of  the  syndicate  of  any  stock 
or  rights  which  may  have  been  sold  for  account  of  the 
syndicate,  and  generally  such  transactions  in  shares 
and  rights  as  they  may  deem  best. 

The  syndicate  is  to  continue  in  force  until  January 


UNDERWRITING  163 

1,  1904,  but  the  managers  may  terminate  it  at  any 
time  on  notice. 

Any  shares  or  subscription  rights  received  by  the 
managers  may  from  time  to  time  be  sold  at  public 
or  private  sale  at  such  prices  as  the  managers  may 
deem  proper. 

In  case  the  managers  shall  distribute  among  the 
subscribers  any  stock  or  rights  during  the  existence  of 
the  syndicate,  it  shall  be  held  by  the  respective  sub- 
scribers subject  to  the  delivery  to  the  syndicate  man- 
agers upon  demand,  and  no  subscriber  shall  prior  to 
the  termination  of  the  syndicate  sell  or  contract  for 
the  sale  of  any  of  the  syndicate  stock  or  rights. 

Third,  it  is  usually,  although  not  invariably,  agreed  that 
the  syndicate  manager  shall  assign  to  the  members  of  the 
syndicate  a  certain  percentage  of  the  profits  on  the  trans- 
action. The  remainder,  sometimes  one  fifth,  sometimes  a 
smaller  amount,  is  reserved  as  his  own  profit. 

Fourth,  the  syndicate  manager  also  reserves  the  right  to 
participate,  up  to  the  amount  of  his  reservation  for  himself, 
as  a  regular  member  of  the  syndicate. 

Fifth,  any  member  of  the  syndicate  may,  at  any  time 
during  its  life,  withdraw  any  of  the  securities  at  the  price 
named  in  his  subscription. 

Sixth,  it  may  be  provided  that  he  may  assign  a  portion 
or  all  of  his  responsibility  to  the  syndicate  manager  or  others, 
and  that,  with  the  consent  of  the  syndicate  manager,  he  may, 
in  this  manner,  be  relieved  of  his  responsibility. 

Seventh,  it  may  be  provided  that  the  members  of  the 
syndicate  are  to  cooperate  with  the  syndicate  manager  in  bor- 
rowing a  portion  of  the  price  of  the  securities  underwritten  or 
subscribed  for,  from  banks,  in  which  case  their  participation 
may  be  put  in  the  form  of  a  negotiable  instrument  so  that  the 
syndicate  manager  can  assign  it  as  additional  security. 

Eighth,  the  syndicate  manager  agrees  to  be  responsible 
for  good  faith  in  the  management  of  the  syndicate,  and  in 
the  distribution  of  profits,  and  for  nothing  else. 

The  terms  of  the  underwriting  agreement  carry  out  the 


164  CORPOKATION   FINANCE 

idea  that  this  is  the  private  enterprise  of  the  synd*icate  man- 
ager, which  the  members  enter  on  the  terms  which  he  pre- 
scribes, and  which  leaves  him  absolute  control  of  all  the 
transactions  necessary  to  carry  out  the  purposes  of  the  syndi- 
cate. His  associates  in  the  syndicate  place  the  whole  manage- 
ment in  his  hands.  He  may  make  or  modify  contracts  in 
the  interest  of  the  syndicate;  he  may  incur  such  expenses  as 
he  deems  necessary;  he  may  buy  or  sell  the  securities  on  the 
market,  and  he  is  frequently  authorized  to  hypothecate  the 
subscriptions  of  the  members  to  provide  the  funds  nec- 
essary for  his  advances  to  the  company. 

A  common  feature  of  large  syndicate  transactions  is  the 
organization  of  sub-syndicates.  These  differ  in  no  essential 
respect  from  the  ordinary  syndicate.  They  are  divisions  of  the 
responsibility  apportioned  by  members  of  the  syndicate  among 
their  own  friends  on  much  the  same  terms  and  conditions 
as  those  to  which  they  have  subscribed  in  the  original  syndi- 
cate agreement.  It  often  happens  that  a  man  will  request  a 
larger  amount  of  participation  in  a  syndicate  than  he  expects 
to  carry,  so  that  he  may  admit  some  of  his  friends  to  share 
in  his  expected  profits,  or  he  may  become  doubtful  of  the 
outcome  of  the  syndicate,  and  may  wish  to  dispose  of  a  part 
or  all  of  his  responsibility  to  others.  As  a  rule,  the  syndicate 
manager  does  not  know  the  members  of  the  sub-syndicate 
any  more  than  the  corporation  knows  the  members  of  the 
original  syndicate.  The  ramifications  of  these  sub-syndicates 
may  be  very  extensive.  The  first  United  States  Steel  Under- 
writing Syndicate,  which  involved  $200,000,000,  for  example, 
it  was  understood,  was  shared  in  by  almost  every  financier 
of  any  importance  in  the  United  States. 

After  the  syndicate  has  been  organized,  the  syndicate 
manager  usually  makes  a  call  upon  the  members  for  a  certain 
percentage,  often  twenty-five  per  cent  of  their  subscriptions. 
This  must  be  paid  in  cash.  With  these  subscriptions  as  a 
basis,  he  borrows  the  balance  of  the  amount  necessary  from 
banks  and  trust  companies  which  may  themselves  be  inter- 
ested in  the  syndicate,  and  therefore  disposed  to  assist  him. 


UNDERWRITING  165 

These  loans  he  may  make  on  his  own  security,  with  the 
pledge  of  the  bonds  or  stocks  which  he  has  underwritten  or 
purchased,  on  the  certificates  representing  these  securities, 
or  he  may,  as  above  described,  pledge  in  addition  the  respon- 
sibility of  the  members  of  his  syndicate.  He  then  sells  the 
stocks  or  bonds  by  the  ordinary  methods  employed  in  market- 
ing securities,  direct  to  the  investor,  indirectly  through  fiscal 
agents,  and  also  by  utilizing  the  various  stock  exchanges  on 
which  the  securities  are  listed.  The  members  of  the  syndicate 
may  act  as  his  agents  and  sell  on  commission. 

The  syndicate  is  organized  for  a  certain  term.  At  the 
end  of  that  term,  if  the  securities  are  not  sold,  two  alter- 
natives are  open,  either  the  syndicate  can  be  extended,  in 
which  case  the  securities  remain  in  the  hands  of  the  syndicate 
manager,  and  the  loans  which  he  has  made  to  supply  the 
cash  to  the  corporation  are  renewed,  or  the  syndicate  is  dis- 
solved. The  proceeds  of  the  securities  which  have  been  sold 
are  then  applied  to  paying  any  loans  which  may  have  been 
incurred,  and  the  unsold  securities  are  distributed  to  the 
members  of  the  syndicate,  according  to  their  several  partici- 
pations, payment  being  made  in  cash.  It  is  customary  to 
make  at  least  one  extension  of  a  syndicate  which  has  not 
been  successful  during  its  original  term,  and  in  some  cases 
syndicates  have  been  extended  several  times. 

The  method  of  dissolving  a  syndicate  is  illustrated  by 
the  following  letter,  addressed  by  J.  P.  Morgan  &  Company, 
managers  of  the  syndicate  which  guaranteed  the  preferred 
stock  conversion  plan  of  the  United  States  Steel  Corporation, 
to  the  syndicate  members. 

PREFERRED    STOCK   RETIREMENT 
SYNDICATE— FINAL  NOTICE 

Dear  Sir:  Referring  to  our  circular  letter  of  Sept. 
14,  1903,  we  beg  to  inform  you  that  we  shall  be  pre- 
pared to  cloee  the  syndicate  account  on  May  17,  1904. 
Your  subscription  to  the  syndicate  was  for  $3,750 
bonds,  of  which  amount  80  per  cent  was  payable  in 
12 


166  CORPOKATION   FINANCE 

preferred  stock  and  20  per  cent  in  cash  at  par  and 
interest. 

Having  delivered  to  you  on  Oct.  1,  1903,  a  portion 
of  the  bonds  payable  in  preferred  stock,  there  remains 
still  to  be  delivered  to  you  the  balance  of  such  bonds, 
amounting  to  $1,000  bonds,  ex-matured  coupons,  ac- 
counted for  below : 

On  Oct.  1,  1903,  we  called  from  you  25 
per  cent  of  your  cash  subscription, 
leaving  still  due  from  you  75  per 
cent  of  such  cash  subscription, 
which,  with  accrued  interest  to  May 
17,    amounts    to $564.18 

Your  share  of  the  amount  standing  to 
the  credit  of  the  sjTidicate  on  May 
17,  1904,  including  interest  at  5 
per  cent  per  annum  on  the  portion 
of  cash  subscription  paid  Oct.  1, 
1903,  will  be $325.50 

To  which  is  added  the  amount  of  cou- 
pons due  Nov.  1,  1903  (7  months), 
and  May  1,  1904,  on  the  undelivered 
portion  of  bonds  payable  in  pre- 
ferred   stock    mentioned    above....     54.18      379.68 


This  leaves  a  balance  due  from  you  in 

final  settlement  of  $184.50 

for  which  kindly  hand  us  your  check  on  Tuesday, 
May  17,  1904,  upon  receipt  of  which  and  upon  sur- 
render of  your  certificate  of  participation,  properly 
indorsed,  we  shall  be  prepared  to  deliver  to  you  all 
the  bonds  subscribed  for  by  you  in  cash,  together  with 
the  balance  of  the  bonds  payable  in  preferred  stock, 
as  stated  above,  making  total  delivery  to  you  at  that 
time  of  $1,750  bonds.  Fractional  amounts  of  bonds 
will  be  adjusted  in  cash. 

(Signed)     J.  P.  Morgan  &  Co. 

The  syndicate  manager  may  not  have  chosen  to  carry  on 
the  operation  with  the  proceeds  of  loans,  and  may  have  called 
upon  the  members  of  the  syndicate  to  pay  up  the  full  amount 


UNDERWRITING  167 

of  their  participations  before  the  term  of  the  syndicate  has 
expired.  In  this  case,  since  they  have  all  paid  for  the  secur- 
ities, the  dissolution  of  the  syndicate  involves  merely  the 
distribution  of  the  unsold  securities  among  the  members. 

In  settling  the  affairs  of  an  underwriting  syndicate,  the 
syndicate  manager  renders  no  accounting  to  the  members, 
nor  is  any  accounting  asked  for.  The  transaction  is  based 
upon  good  faith,  and  legal  guarantees  are  not  required. 
There  is  no  instance  on  record  where  a  banking  house  of 
good  reputation  was  sued  for  an  accounting  by  members  of 
a  syndicate  which  it  had  organized.  If  crookedness  or  sharp 
dealing  were  attempted  by  a  syndicate  manager,  even  though 
he  renders  no  accounting,  the  fact  would  soon  become  known, 
and  would  make  it  impossible  for  him  to  secure  participa- 
tion in  future  syndicates.  Thus  the  accounting  is  really  not 
necessary  in  order  to  insure  fair  dealing.  Furthermore,  if 
any  member  of  a  syndicate  fails  to  pay  for  his  bonds  as 
requested,  no  proceedings  are  instituted  against  him  by  the 
syndicate  manager.  He  is  simply  dropped  from  the  man- 
ager's list,  and  it  may  be  difficult  for  him  to  obtain  financial 
assistance  or  an  opportunity  to  participate  in  profitable  finan- 
cial operations  in  the  future.  Instances  of  such  failure  are, 
however,  rare.  The  consequences  to  a  man's  reputation  are 
serious,  and  syndicate  members  will  strain  every  resource, 
and  will  dispose  of  their  participations  even  at  a  heavy  sacri- 
fice, in  order  to  make  good  their  word  to  the  syndicate 
manager. 

Participations  in  underwriting  and  subscription  syndi- 
cates are  sometimes  very  profitable.  If  market  conditions  are 
auspicious,  it  frequently  happens  that  the  entire  issue  of  se- 
curities may  be  sold  to  the  public  before  any  calls  are  made 
upon  the  subscriber.  Usually,  however,  a  portion  of  the 
subscription  is  called,  but  if  the  syndicate  is  successful,  only 
one  call  is  likely  to  be  made.  The  syndicate  which  subscribed 
$200,000,000  to  assist  in  the  flotation  of  the  United  States 
Steel  Corporation,  paid  in  $25,000,000  and  received  back 
$65,000,000.     On  the  other  hand,  the  security  markets  may 


168  COKPOKATION  FINANCE 

be  unfavorable,  owing  to  stringent  money  markets,  or  to  dis-' 
trust  of  some  classes  of  investments,  and  syndicates  may  be 
left  with  large  amounts  on  their  hands  which  their  members 
must  carry,  sometimes  for  years,  before  they  can  dispose  of 
them  at  a  profit.  An  example  of  this  failure  is  furnished  by 
the  dissolution  of  the  syndicate  which  underwrote  the  con- 
vertible bond  issue  of  $12,000,000  for  the  Erie.  The  syndi- 
cate was  dissolved  in  January,  1907,  with  three  fourths  of  the 
bonds  remaining  on  hand.  The  failure  of  the  International 
Mercantile  Marine  bond  syndicate  whose  members  were  forced 
to  take  practically  all  the  bonds,  also  shows  how  uncertain 
are  the  profits  in  these  ventures.  Syndicate  participations 
are  frequently  taken  by  investors  and  financial  institutions 
in  order  to  secure  bonds  at  a  lower  price  than  could  be  had 
from  any  other  source  of  supply.  This  practice  gave  rise 
to  grave  abuses,  since  participation  for  directors  and  officers 
of  life  insurance  companies,  for  example,  would  be  carried 
by  the  company,  at  the  company's  risk,  with  nothing  but  a 
general  understanding  that  it  would  be  indemnified  by  the 
beneficiary  for  any  loss.  Such  participations  are  now  illegal 
in  New  York  for  insurance  companies. 


CHAPTEE   XIV 
THE  DETERMINATION  OF  PROFITS 

The  financing  of  the  corporation  has  now  been  com- 
pleted. The  money  for  the  construction  of  its  plant  and  the 
inauguration  of  its  business  has  been  paid  into  its  treasury; 
its  construction  work  has  been  completed;  it  has  been  for- 
mally launched  as  a  going  concern.  We  have  next  to  con- 
sider the  determination  of  its  profits  in  order  to  indicate 
the  principles  which  govern  their  management  and  dis- 
tribution. 

The  subject  of  corporation  finance  is  not  concerned  with 
the  methods  by  which  profits  are  made.  The  principles  of 
profit  making  are  of  general  application,  and  are  not  affected 
by  the  form  of  organization  under  which  a  business  is  con- 
ducted. They  are  alike  for  the  partnership  and  for  the  cor- 
poration. It  is,  however,  of  peculiar  importance  to  a  corpo- 
ration, even  more  important  than  to  a  partnership,  that  its 
profits  should  be,  at  regular  intervals,  accurately  determined. 
The  partnership  or  the  private  corporation,  whose  owners 
are  in  close  touch  with  its  affairs,  may  tolerate  a  degree  of 
laxity  or  inaccuracy  in  the  determination  of  its  profits.  If 
too  much  is  drawn  from  the  business  in  one  year,  the  draw- 
ing accounts  of  the  partners  may  be  reduced  the  year  follow- 
ing. If  profits  are  overestimated,  and  the  business  on  that 
account  is  too  rapidly  expanding,  it  may  be  possible,  by 
economizing  and  contracting  the  scale  of  operations,  for  the 
concern,  without  injury  to  its  credit,  to  regain  its  former 
position.  These  private  corporations,  moreover,  grow  out 
of  earnings.  They  do  not  so  often  appeal  to  the  outside 
investor,  as  the  public  corporation  is  forced  to  do,  for  funds 

169 


170  CORPOKATION   FINANCE 

with  which  to  enlarge  their  business.  Their  shares  and  evi- 
dences of  debt  are  not  dealt  in  on  the  public  exchanges.  Part- 
nership interests  are  not  expressed  in  negotiable  form,  and 
the  shares  of  private  corporations  are  to  a  less  extent  em- 
ployed as  collateral  for  loans.  For  these  reasons,  while  it 
is  essential  for  every  business  enterprise  to  ascertain  its  ex- 
act financial  status  at  fixed  intervals,  the  accurate  determina- 
tion of  profits  for  the  partnership  or  the  private  corporation 
is  less  essential  than  for  the  public  corporation. 

The  stocks  and  bonds  of  public  corporations  which  ap- 
peal to  the  investor  to  provide  them  capital,  are  widely  held 
by  individuals  and  institutions  who  draw  income  from  these 
securities.  This  interest  should  be  regularly  paid,  and  divi- 
dends should  be  distributed  without  serious  and  sudden 
changes  in  their  rates.  These  regular  payments  can  only 
be  counted  on  if  the  fund  out  of  which  they  are  to  be  made 
is  exactly  determined.  The  securities  of  public  corporations, 
moreover,  are  usually  listed  on  the  exchanges  and  are  bought 
and  sold  every  day.  A  free  market  for  their  securities  is  of 
great  importance  to  corporations.  They  are  enabled,  by  this 
means,  to  obtain,  from  time  to  time,  additional  sums  of  money 
for  the  enlargement  of  their  business.  A  primary  essential 
to  a  free  market  is  accurate  information  concerning  the 
financial  status  of  the  companies  issuing  these  securities. 
Corporation  stocks  and  bonds  are  .deposited  in  enormous 
amounts  with  banks  and  trust  companies  as  collateral  for 
loans,  and  the  bank  cannot  lend  intelligently,  unless  it  is 
placed  in  the  possession  of  all  essential  information  concern- 
ing the  affairs  of  the  enterprise. 

It  is  not  merely  necessary  that  their  profits  should  be 
accurately  determined  by  public  corporations,  but  it  is  equally 
essential  that  they  should  be  stated  m  simple  and  intelligible 
form,  so  that  the  investor  and  the  banker  can,  without  diffi- 
culty, reach  an  accurate  conclusion  as  to  their  earning  power 
and  financial  condition.  For  a  long  time,  American  railway 
companies  did  not  recognize  the  necessity  of  making  such 
statements  of  assets  and  earnings,  and  their  stocks  were  the 


I 


THE  DETERMINATION   OF  PROFITS         171 

objects  of  speculation  which  always  thrives  upon  uncertainty. 
This  condition  has  long  since  passed  away.  The  reports  of 
our  railroad  companies,  even  before  the  law  compelled  them 
to  make  an  accurate  determination  of  their  profits  and  a  full 
statement  of  their  financial  condition,  leave  little  to  be  desired. 
The  industrial  corporations  are  more  remiss  in  making  state- 
ments of  their  condition.  Until  the  United  States  Steel 
Corporation  set  the  example  by  publishing  what  is,  probably, 
the  most  satisfactory  report  of  any  of  the  large  industrials, 
officials  of  these  corporations  generally  refused  to  give  infor- 
mation, on  the  ground  that  disclosure  of  the  condition  of 
their  business  would  give  an  advantage  to  their  competitors. 
In  time,  however,  this  aversion  to  revealing  the  condition 
of  their  affairs  was  worn  away  by  the  necessity  of  obtaining 
a  broad  market  for  their  securities,  which  could  not  be  had 
without  some  information  upon  which  the  investor  could  base 
his  judgment.  The  reports  of  industrial  corporations  are 
still,  as  a  class,  far  from  being  as  complete  as  the  reports  of 
the  railroads.  Street  railway  and  public  service  corporations 
generally  give  even  more  meager  information  than  do  the 
industrials.  Steady  improvement  in  the  direction  of  pub- 
licity is,  however,  everywhere  evident.  Even  if  the  laws  do 
not  intervene  to  compel  full  statements  of  income  and  ex- 
penditures, assets  and  liabilities,  the  force  of  financial  opin- 
ion may  be  relied  upon  to  accomplish  this  result. 

It  is  not  necessary,  as  corporation  officials  have  feared, 
that  the  amount  of  information  which  is  necessary  to  acquaint 
the  investor  with  the  financial  condition  of  the  property  in 
which  he  is  interested  should  involve  the  disclosure  of  the 
secrets  of  the  business.  This  may  be  illustrated  by  an  in- 
stance related  by  a  public  accountant,  which  shows  the  pos- 
sibility of  harmonizing  publicity  for  the  investor  with  se- 
crecy as  to  essential  details  with  which  the  investor  had  no 
legitimate  concern.  The  accountant  was  engaged  to  make 
a  report  on  a  newspaper  property  which  was  about  to  be  sold 
by  order  of  the  court.  The  report  was  especially  full  and 
detailed,  but  not  sufficiently  explicit  to  suit  certain  persons. 


172  COEPOKATION   FINANCE 

who  requested  information  as  to  the  returns  from  adver- 
tising and  the  amount  paid  for  salaries.  The  Master  in 
Chancery  refused  to  allow  this  information  to  be  given  on 
the  ground  that  the  competitors  would  discover  the  secrets 
of  the  business.  The  accountant  pointed  out,  however,  that 
by  presenting  merely  the  totals,  without  mentioning  indi- 
vidual items,  this  danger  could  be  avoided,  and  at  the  same 
time  the  investor  could  be  fully  informed.  The  competitors 
of  this  paper  could  not  have  profited  from  information  as 
to  the  aggregate  salaries  paid  or  the  total  amount  of  advertis- 
ing receipts.  What  they  were  concerned  to  discover,  was  the 
amount  paid  to  certain  individuals  on  the  staff,  and  the 
terms  of  particular  advertising  contracts.  This  information, 
however,  would  have  been  of  no  assistance  to  the  investor, 
and  could  easily  have  been  dispensed  with. 

Eecognizing  the  necessity,  from  the  standpoint  of  the 
public  corporation,  that  its  profits  should  be  exactly  ascer- 
tained, and  that  clear  and  intelligible  statements  of  its  con- 
dition should  be  made,  we  proceed  to  consider  the  methods 
by  which  the  determination  of  profits  is  accomplished.  The 
profits  of  a  corporation  may  be  defined  as  the  increase  in 
the  net  worth  of  a  corporation  over  a  given  period.  The 
net  or  present  worth  of  a  business  consists  of  the  difference 
between  assets  and  liabilities.  In  a  manufacturing  concern, 
the  statement  of  assets  and  liabilities  of  a  given  year  might 
be  as  follows  on  January  1st : 

Assets  Liabilities 

Plant $1,000,000    Capital  stock $100,000 

Accounts  receivable. .  .        500,000     Bonds  secured  by  mort- 

Materials  and  supplies       300,000        gage 500,000 

Cash 250,000     Pay-rolls,       vouchers, 

etc 200,000 

Surplus .  .  .-ST-. 1,250,000 

$2,050,000  $2,050,000 

On  December  31st  of  the  same  year,  if  the  business  had 
been  prosperously  conducted,  and  no  withdrawals  had  been 
made,  the  statement  might  be  as  follows : 


THE  DETERMINATION   OF   PROFITS         173 

Assets  Liabilities 

Plant $1,250,000    Capital  stock $200,000 

Accounts  receivable. . .        600,000    Bonds 500,000 

Materials  and  supplies       400,000    Pay-rolls,       vouchers, 

Cash 350,000        etc 350,000 

Net  present  worth 1,550,000 

$2,600,000  $2,600,000 

The  results  of  this  comparison  would  show  in  the  follow- 
ing table  of  differences: 

Net  present  worth,  January  Ist $1,250,000 

"         "  "       December  31st 1,550,000 


Increase $300,000 

It  appears  that  the  net  present  worth,  the  difference  be- 
tween assets  and  liabilities,  usually  called  the  "  surplus,"  has 
increased  $300,000  during  the  year.  The  company  has  suc- 
ceeded in  increasing  its  assets  over  the  increase  in  its  liabil- 
ities by  this  amount.  During  the  year,  however,  various  pay- 
ments will  have  usually  been  made  on  account  of  interest 
and  dividends.  The  amount  of  these  payments  must  be  added 
to  the  increase  in  surplus  in  order  to  ascertain  the  profits 
of  the  year. 

The  profits  of  a  business  are  expressed  in  the  following 
form  which  is  used  by  the  International  Harvester  Company 
to  express  the  results  of  its  business  during  1908: 

1908 

Total  sales $72,541,771 

Manufacturing  and  distributing  cost 59,615,222 


Net  earnings  from  operation $12,926,549 

Miscellaneous  income 524,598 


Total  income $13,451,147 

Administrative  and  general  expenses 520,769 

Net  income $12,930,378 


174  COEPOKATION   FINANCE 

Charges: 

Total  deductions $4,044,695 

Net  profits $8,885,683 

Dividends 4,200,000 

Undivided  profits $4,685,683 

Previous  surplus 12,006,306 


This  form,  with  ■animportant  modifications,  is  used  by 
every  corporation  which  makes  any  report  of  its  condition. 
We  start  with  gross  earnings,  the  product  of  sales  or  com- 
modities, services  or  contracts,  according  as  the  business  is 
a  manufacturing  or  jobbing  company  or  a  bank  or  insurance 
company.  From  the  gross  earnings  of  the  International  Har- 
vester Company  for  1908  these  sales  were  $72,541,771.  From 
these  gross  earnings  are  deducted  the  cost  of  running  the 
business,  maintaining  the  plant,  and  selling  the  product.  For 
the  International  Harvester  Company,  this  amount  was  $59,- 
615,222.  The  difference  between  the  receipts  and  the  pay- 
ments represents  the  net  earnings  from  operation,  in  the 
above  statement,  $12,926,549.  To  this  amount  must  be 
added  items  grouped  under  the  head  of  other  income.  For 
the  International  Harvester  Company,  this  "  other  income  " 
was  comparatively  small,  only  $524,598,  leaving  total  income 
at  $13,451,147.  This  company  next  deducts  administrative 
and  general  expenses  before  arriving  at  the  balance  of  net 
income.  It  is  a  common  practice  to  include  administrative 
and  general  expenses  with  operating  expenses.  Making  this 
last  deduction,  we  arrive  at  the  total  of  net  income  of  the 
International  Harvester  Company  of  $12,930,378.  This  rep- 
resents the  combined  earnings  and  income  of  the  business 
during  the  calendar  year  ending  December  31,  1908. 

Various  claimants  now  appear  to  this  income.  First 
comes  the  state  which  receives  taxes;  then  the  creditor  with 
his  demand  for  interest  and  sinking  funds ;  then  the  corpora- 
tion demanding  that  its  plant  shall  be  fully  maintained, 
and  that  provision  shall  be  made  against  the  day  when  it 
is  worn  out;  also  asking  money  for  insurance  and  losses  inci- 


THE  DETERMINATION  OF   PROFITS         175 

dent  to  the  conduct  of  the  business.  There  is  also  the  claim 
of  the  owner  of  property  which  the  corporation  holds  under 
lease,  known  as  rentals.  These  deductions,  added  together, 
make  the  "  total  deductions  "  by  the  International  Harvester 
Company  from  income,  before  the  owners  can  draw  anything 
from  the  business,  $4,044,695.  Deducting  this  amount  from 
the  net  income,  there  is  a  balance  available  for  distribution 
to  stockholders  of  $8,885,683.  This  company  has  $120,000,- 
000  of  capital  stock,  equally  divided  between  preferred  and 
common  stock.  The  preferred  stock  pays  seven  per  cent 
dividends  and  the  dividend  is  cumulative.  It  is  necessary, 
if  the  profits  permit,  that  dividends  on  the  preferred  stock 
should  be  paid.  Seven  per  cent  on  $60,000,000  of  preferred 
stock  calls  for  a  distribution  of  $4,200,000,  leaving  $4,685,- 
683  for  the  common  stock.  The  directors  of  the  Interna- 
tional Harvester  Company  have  recently  declared  a  dividend 
on  the  common  stock.  At  the  date  of  this  report,  however, 
the  business  needed  money  for  its  development;  it  was  not 
deemed  wise  to  pay  any  common  dividend,  and  the  undivided 
profits,  amounting  to  $4,685,683,  were  retained  in  the  busi- 
ness. This  amount  was  now  transferred  from  the  income 
account  to  the  balance  Sheet,  increasing  the  excess  of  assets 
over  liabilities  from  $12,600,307  to  $16,691,989. 

This  addition  to  the  surplus  was  accomplished  by  an 
increase  in  certain  assets  of  the  comj)any  and  a  decrease  in 
certain  liabilities  which  appear  in  the  table  on  page  176. 
The  balance  sheet  surplus  represents  the  accumulations  of 
undisturbed  profits  over  a  series  of  years.  It  may,  in  turn, 
be  distributed  by  a  readjustment  of  the  capitalization  ac- 
cording to  methods  which  will  be  discussed  in  a  later  chapter. 

Having  now  defined  the  surplus  of  a  corporation,  we  have 
next  to  examine  the  sources  from  which  these  profits  are 
derived.    We  find  these  to  be  as  follows: 

First,  income  arising  directly  from  the  company's  busi- 
ness. 

Second,  premiums  on  the  sale  of  stocks  and  bonds  of 
the  company. 


176 


COKPOKATION   FINANCE 


Assets 

1908 

1907 

Property  account 

$63,680,776 

189,683 

400,832 

33,854,933 

13,832,123 

25,471,132 

10,840,098 

9,339,055 

$157,608,632 

$62,844,136 
285  288 

Deferred  charges  to  operations 

Insurance  fund  assets . .    . 

Finished  products,  raw  material,  etc  .... 
Material  purchased  for  current  season. . . 
Farmers'  and  agents'  notes 

35,140,416 
15,147,210 
26,583,001 

12,708,509 

3,573,894 

$156,282,454 

Accounts  receivable  less  contingent  re- 
serve   

Cash 

Total 

Liabilities 

Preferred  stock 

$60,000,000 
60,000,000 

$60,000,000 

60,000,000 

3,450,195 

10,465,775 

4,543,443 

1,050,000 

4,766,734 

12,006,307 

$156,282,454 

Common  stock 

Purchase  money  obligations 

Bills  payable 

8,286,664 

4,729,387 

1,050,000 

6,850,540 

16,692,041 

$157,608,632 

Audited  vouchers,  accrued  interest,  taxes 
etc 

Preferred  dividend  payable 

Reserves 

Surplus 

Total 

Third,  profits  arising  from  the  sale  of  other  assets  of  the 
company  no  longer  needed  for  its  business. 

Fourth,  profits  arising  from  a  revaluation  of  the  com- 
pany's property. , 

We  have  now  to  consider  these  sources  of  profits  from 
the  standpoint  of  an  accurate  determination  of  their  several 
accounts.  Gross  earnings  represent  the  receipts  from  the 
sale  of  services,  contracts,  or  commodities.  These  receipts 
are  in  the  form  either  of  cash  or  of  promises  to  pay  cash. 
In  ascertaining  their  amount,  it  is  necessary  to  exclude  all 
items  such  as  rebates  to  customers  and  cash  discounts.  When 
the  business  is  carried  on  among  several  departments  or  sub- 
companies,  all  sales  between  departments  or  subsidiary  com- 
panies should  also  be  excluded.  It  is  also  necessary  to  ex- 
clude all  bad  or  doubtful  debts  and  accounts. 


THE   DETEKMINATION   OF   PROFITS         177 

Operating  expenses  are  divided  into  two  general  classes: 
expenses  incurred  in  operating  the  plant;  and  expenses  in- 
curred in  keeping  the  plant  in  good  condition.  A  railroad 
company  divides  its  operating  expenses  into  five  classes, 
namely,  maintenance  of  way  and  structures;  maintenance 
of  equipment;  conducting  transportation,  traffic,  and  general 
expenses.  The  nature  of  these  expenses  may  be  understood 
from  some  of  the  items  under  each  classification.  The  largest 
items  under  maintenance  of  way  and  structure  are  track 
maintenance,  road  cleaning  and  ballasting,  rails,  ties,  build- 
ings and  grounds  and  track  material.  Under  maintenance 
of  equipment,  the  largest  items  are  repairs  of  locomotives, 
repairs  of  passenger  and  freight  cars,  and  repairs  of  tools 
and  machinery.  Under  conducting  transportation,  we  find 
the  following  principal  items: 

Station  service,  • 

Eoad  men. 

Road  enginemen  and  firemen, 

Fuel  for  locomotives. 

Engine  house  men. 

Trainmen, 

Telephone  and  telegraph. 

The  general  expenses  and  the  traffic  expenses  consist  mainly 
of  salaries  paid  to  employees  and  officials. 

We  have  here  illustrated  the  essential  distinction  between 
the  cost  of  running  the  road  and  the  cost  of  maintaining  it. 
All  those  expenses  involved  in  obtaining  freight  and  pas- 
sengers, in  receiving  and  caring  for  them,  in  transporting 
and  delivering  them  in  safety  to  their  destination,  are  classed 
under  the  head  of  traffic  and  conducting  transportation. 
Those  expenses,  on  the  other  hand,  which  result  in  keeping 
the  plant  of  the  railway,  its  track,  bridges,  stations,  cars,  loco- 
motives, round  houses,  repair  shops,  in  good  condition  and  in 
efficient  working  order,  are  classed  under  maintenance  ex- 
penses, and,  for  purposes  of  convenience  in  railway  account- 
ing, are  divided  into  Maintenance  of  Way  and  Structure,  and 
Maintenance  of  Equipment. 


178  CORPORATION   FINANCE 

The  cost  of  operation — in  the  railway  field,  the  cost  of 
conducting  transportation — need  not  further  concern  us.  Its 
principles  vary  with  every  industry,  and  have  no  special 
significance  for  the  subject  of  corporation  finance.  The  cost 
of  maintenance,  however,  is  a  division  of  operating  expenses 
in  which  rules  and  principles  have  been  developed  of  general 
application,  and  of  peculiar  importance  in  interpreting  the 
financial  operations  of  public  corporations. 

The  maintenance  of  physical  property  involves  the  fol- 
lowing: First,  the  establishment  of  certain  standards  of 
physical  condition  which  may  be  either  printed  in  books  of 
rules  or  may  exist  only  in  the  minds  of  foremen  and  super- 
intendents; second;  the  expenditure  of  money  on  labor,  ap- 
pliances and  materials  in  order  to  keep  the  property  in  a 
condition  corresponding  to  this  standard.  A  standard,  for 
example,  for  a  railway  track  is  a  description  of  the  track 
and  roadway  as  it  ought  to  be,  in  other  words,  an  ideal  which 
the  Maintenance  of  Way  Department  is  constantly  striving 
to  attain,  but  which,  while  they  may  never  fall  far  below, 
they  never  quite  reach.     The  accompanying  diagram  gives 


in  cross  section  the  standard  roadbed  adopted  by  the  Penn- 
sylvania Railroad.  This  diagram  represents  the  condition  of 
the  roadbed  as  it  should  be  if  it  is  to  be  preserved  at  its 
highest  eflBciency.  This  diagram  is  supplemented  and  ex- 
plained by  specifications  which  furnish  detailed  direction 
to  the  Maintenance  of  Way  Department  as  to  the  methods 


THE   DETEKMINATION   OF   PEOFITS         179 

wliich  must  be  followed  in  keeping  the  track  in  repair.  Some 
of  these  specifications  are  as  .follows  for  the  Pennsylvania 
Railroad  Company: 

1.  Roadbed.  The  surface  of  the  roadbed  should  be 
graded  to  a  regular  and  uniform  subgrade,  sloping 
gradually  from  the  centre  toward  the  ditches. 

2.  Ballast.  There  shall  be  a  uniform  depth  of  six 
(6)  to  twelve  (12)  inches  of  well-broken  stone,  or 
gravel,  cleaned  from  dust,  by  passing  over  a  screen  of 
one-quarter-inch  mesh,  spread  over  the  roadbed,  and 
surfaced  to  a  true  grade,  upon  which  the  ties  are  to 
be  laid.  After  the  ties  and  rails  have  been  properly 
laid  and  surfaced,  the  ballast  must  be  filled  up  as 
shown  on  standard  plan;  and  also  between  the  main 
tracks  and  sidings  where  stone  ballast  is  used.  All 
stone  ballast  to  be  of  uniform  size;  the  stone  used 
must  be  of  an  approved  quality,  broken  uniform- 
ly, not  larger  than  a  cube  that  will  pass  through  a 
two-inch  ring.  On  embankments  that  are  not  well 
settled,  the  surface  of  the  roadbed  shall  be  brought 
up  with  cinder,  gravel,  or  some  other  suitable  ma- 
terial. 

3.  Cross-ties.  The  ties  are  to  be  regularly  placed 
upon  the  ballast.  They  must  be  properly  and  evenly 
placed,  with  ten  (10)  inches  between  the  edges  of  bear- 
ing surface  at  joints,  with  intermediate  ties  evenly 
spaced;  and  the  ends  on  the  outside  on  double  track, 
and  on  the  right-hand  side  going  north  or  west  on 
single  track,  lined  up  parallel  with  the  rails.  The 
ties  must  not  be  notched  under  any  circumstances; 
but,  should  they  be  twisted,  they  must  be  made  true 
with  the  adze,  that  the  rails  may  have  an  even  bear- 
ing over  the  whole  breadth  of  the  tie.  For  all  tracks 
on  main  line  and  branch  roads,  the  rules  governing 
the  use  of  cross-ties  shall  be  as  follows: 

a.  First-class  cross-ties  shall  be  used  in  tracks  where 
passenger  and  freight  trains  run  at  full  speed. 

h.  For  tracks  where  the  trains  run  at  slow  speed, 
new  second-class  ties  shall  be  used.  For  all  tracks 
in  yards,  or  temporary  tracks  laid  for  construction 
purposes  or  otherwise,  second-class  and  cull  ties,  or 


180  COKPORATION   FINANCE 

good  second-hand  ties  taken  out  of  main  track  shall 
be  used. 

Specifications  for  Cross-ties,  Revised  March  24, 
1902. 

Kind  of  Timber. — The  approved  timber  for  cross-ties 
shall  be  White  Oak,  Rock  Oak,  Burr  Oak,  Post  Oak, 
Locust,  Walnut,  Yellow  Pine  or  Chestnut.  Other 
kinds  of  wood  will  not  be  accepted,  unless  regularly- 
ordered  and  specified. 

Quality  and  Manufacture. — The  timber  should  be 
cut  in  the  fall  and  winter,  say  from  September  1st  to 
March  1st.  All  ties  must  be  cut  from  good  sound  liv- 
ing timber,  well  manufactured  to  size  and  length, 
straight,  free  from  large,  loose  or  decayed  knots,  splits, 
shakes  or  any  other  defects  that  may  impair  the 
strength  and  durability  of  the  timber  for  the  purpose 
intended;  pole  ties  must  have  two  parallel  face  sides, 
hewn  or  sawed  with  the  grain  of  the  wood  out  of  wind 
or  twist,  and  stripped  of  bark;  square-sawed  ties  must 
be  sawed  with  the  grain  of  the  wood ;  square-hewed  ties 
may  be  made  of  split  timber,  but  must  be  straight  and 
out  of  wind  or  twist.  Yellow  pine  must  be  long  leaf, 
grown  in  the  interior  belt  of  Georgia,  Florida,  Ala- 
bama or  Mississippi.  Yellow  pine  ties  must  be  square, 
and  may  be  hewed  or  sawed ;  the  heart  should  be  in  the 
center  and  not  more  than  one  inch  of  sap,  measured  on 
the  face  or  side,  will  be  allowed  on  each  corner.  All 
ties  must  be  sawed  off  square  at  the  ends. 

Pole  ties  less  than  six  inch  face,  square  sawed  or 
square-hewed  ties  less  than  seven  inch  face,  and  Yel- 
low Pine  ties  less  than  eight  inch  face,  will  be 
classed  as  culls,  and  will  not  be  accepted  unless  spe- 
cially ordered. 

Classes  of  Ties. — The  following  table  [see  page  181] 
shows  the  kind,  size  and  permitted  variation  of  cross- 
ties: 


THE   DETERMINATION   OF   PROFITS 


181 


:^ 


^ 


^»         t>.         t^ 


^ 


:s: 


«     1 

'i    : 


a  -a  -a  •         e 

^  ;        _o  :        S  '.        S 

fQ  •  (O  -CD  •  o 


^         o 


rt  t^ 


13 


182  CORPOKATION   FINANCE 


c.  On  all  running  tracks  where  the  weight  of  rail  is 
seventy  pounds  per  yard  and  over,  fourteen  ties  shall  be 
used  to  each  thirty  feet  of  track,  and  for  all  tracks  in 
yards  and  for  temporary  use,  not  more  than  twelve 
ties  shall  be  used  for  each  thirty  feet  of  track. 

Line  and  Surface. — The  track  shall  be  laid  in  true 
line  and  surface;  the  rails  are  to  be  laid  and  spiked 
after  the  ties  have  been  bedded  in  the  ballast ;  and  on 
curves,  the  proper  elevation  must  be  given  to  the  outer 
rail  and  carried  uniformly  around  the  curve.  This 
elevation  should  be  commenced  from  fifty  (50)  to  three 
hundred  (300)  feet  back  of  the  point  of  curvature,  de- 
pending on  the  degree  of  the  curve  and  speed  of  trains, 
and  increased  uniformly  to  the  latter  points  where  the 
full  elevation  is  attained.  The  same  method  should  be 
adopted  in  leaving  the  curve. 

d.  In  removing  cross-ties  from  the  main  tracTcs,  they 
shall  he  tahen  out  only  as  they  hecome  unfitted  for 
service,  in  the  manner  generally  hnown  as  "spotting 
ties,"  and  not  hy  entire  renewals  in  continuous  sec- 
tions, and  Subdivision  Foremen  will  he  held  responsi- 
ble for  the  proper  observance  of  this  rule.  It  shall  be 
the  duty  of  the  Supervisor  or  his  assistant  to  walk 
over  the  track  with  the  Foreman  and  personally  in- 
spect the  ties  to  be  renewed  before  he  authorizes 
the  same  to  be  taken  out  and  replaced  with  the  new 


Ditches. — The  cross-section  of  ditches  at  the  high- 
est point  must  be  the  width  and  depth  as  shown  on 
the  standard  drawing,  and  graded  parallel  with  the 
track,  so  as  to  pass  water  freely  during  heavy  rains 
and  thoroughly  drain  the  ballast  and  roadbed.  The 
line  of  the  bottom  of  the  ditch  must  be  made  par- 
allel with  the  rails,  and  well  and  neatly  defined,  at 
the  standard  distance  from  the  outside  rail.  All  nec- 
essary cross  drains  must  be  put  in  at  proper  intervals. 
Earth  taken  from  ditches  or  elsewhere  must  not  be  left 
at  or  near  the  ends  of  the  ties,  thrown  up  on  the 
slopes  of  cuts,  nor  on  the  ballast,  but  must  be  de- 
posited over  the  sides  of  embankments.    Berm  ditches 


THE   DETEKMINATION   OF   PROFITS         183 

shall  be  provided  to  protect  the  slopes  of  cuts,  where 
necessary.  The  channels  of  streams  for  a  considerable 
distance  above  the  road  should  be  examined,  and  brush, 
drift  and  other  obstructions  removed.  Ditches,  cul- 
verts and  box  drains  should  be  cleared  of  all  obstruc- 
tions, and  the  outlets  and  inlets  of  the  same  kept  open 
to  allow  a  free  flow  of  water  at  all  times. 


Similar  standard  specifications  exist  for  every  part  of 
the  railroad's  property.  It  is  the  duty  of  the  Maintenance 
Departments  to  see  that  the  property  is  always  kept  in  this 
condition.  A  variety  of  agencies  are  constantly  at  work  to 
lower  these  standards.  The  pounding  of  heavy  trains  throws 
the  track  out  of  alignment,  grinds  the  ballast  to  powder, 
wears  the  rails,  especially  on  the  curves,  and  loosens  the 
spikes  and  fish  plates.  And  while  the  locomotives  and  cars 
are  destroying  the  track  they  are  constantly  destroying  them- 
selves. Wheels  become  worn,  frames  loose,  paint  wears  off, 
glass  is  broken,  boiler  tubes  are  filled  with  scale,  furniture 
and  fittings  become  dirty  and  dingy. 

While  the  running  of  the  trains  is  doing  all  this  damage, 
the  agencies  of  nature  are  ceaselessly  at  work  upon  the 
roadway.  Rain,  sun,  frost  and  running  water  are  constantly 
wearing  away  the  roadway.  Water  seeps  into  the  ties  around 
the  spikes,  carrying  in  bacteria  and  fungi,  and  in  time  the 
wood  decays.  In  the  spring,  when  the  ground  thaws,  the 
track  is  lifted  and  wrenched  out  of  line  and  surface;  erosion 
is  constantly  filling  up  the  ditches  and  damming  up  water 
which  settles  around  the  ballast  and  helps  on  the  disintegra- 
tion of  the  roadbed.  The  ballast,  from  its  own  weight  and 
that  of  the  track  and  trains,  settles  into  the  ground.  Sun- 
shine, wind  and  rain  unite  to  destroy  paint  and  timbers. 
Frost  makes  rails  and  fastenings  brittle.  All  these  manifold 
agencies  of  destruction  are  incessantly  at  work  to  pull  down 
the  road  below  its  established  standard. 

The  property  of  the  railroad  is  also  subjected  to  occasional 
accidents,  sometimes  rising  to  the  dignity  of  catastrophes. 
Streams  may  flood  and  wash  away  large  sections  of  track 


184  COKPOKATION   FINANCE 

and  numerous  bridges,  railway  terminals  may  be  destroyed 
by  fire,  numerous  train  wrecks  from  collisions  or  derailments 
are  constantly  occurring,  destroying  large  amounts  of  prop- 
erty. It  is  the  business  of  the  Maintenance  Department  to 
combat  these  forces  of  destruction,  and  to  repair  the  damage 
which  is  incessantly  being  inflicted  upon  the  property  of  the 
company.  The  track  and  equipment  of  a  railway  are  the 
subject  of  constant  inspection  and  close  scrutiny. 
^  The  work  of  the  Maintenance  Department  of  a  corpora- 
tion may  be  illustrated  from  the  Maintenance  and  Repair 
Shop  Practice  of  the  Interborough  Rapid  Transit  Company 
described  in  the  Street  Railway  Journal  for  April  25th 
and  May  23,  1908.  This  department  has  charge  of  keeping 
in  good  condition  all  the  cars  on  the  elevated  and  subway 
lines  on  Manhattan  Island.  The  work  is  done  in  two  shops, 
one  at  Ninety-eighth  Street  and  Third  Avenue,  and  the 
other  at  148th  Street  and  Lenox  Avenue.  These  shops  are 
equipped  with  machine  tools,  electric  hoists  and  cranes,  and 
the  Ninety-eighth  Street  shop  contains  in  addition  a  brass 
foundry  and  a  paint  shop.  When  a  car  needs  any  overhaul- 
ing or  repairs  it  is  put  into  the  shop,  the  elevated  cars  at 
Ninety-eighth  Street  and  the  subway  cars  at  148th  Street. 
The  selection  of  cars  for  overhauling  is  made  on  the  basis 
of  mileage.  For  the  elevated  roads,  it  is  assumed  that  a  car 
will  run  65,000  miles  before  it  needs  attention.  This  stand- 
ard has  been  modified  for  the  subway  cars  so  that  each  piece 
of  equipment  in  the  car,  and  the  car  itself,  has  a  predeter- 
mined mileage  which  it  is  supposed  to  run  before  needing 
attention.  As  fast  as  this  mileage  is  reached,  the  car  is  put 
into  the  shop  and  that  particular  part  is  overhauled.  By  this 
method  the  entire  car  does  not  need  attention  every  time 
it  reaches  the  shop.  In  the  case  of  accidents  to  cars,  gen- 
eral overhauling  and  complete  repair  may  be  necessary  before 
the  standard  mileage  has  been  reached. 

The  nature  of  the  work  done  in  these  shops  may  be  illus- 
trated from  the  practice  followed  in  painting  the  cars.  Paint- 
ing records  and  records  of  inspection  for  painting  show  the 


THE   DETEKMINATION   OF   PROFITS         185 

date  the  car  was  last  in  the  shop,  the  date  last  inspected, 
the  date  it  should  be  sent  to  the  shop,  and  the  class  of  paint- 
ing for  which  it  is  due.  The  cars  are  graded  in  four  classes 
with  regard  to  the  condition  of  the  paint:  Class  A,  to  be 
burned  off  and  repainted  from  the  wood  up.  B,  to  be  scraped 
thoroughly,  cut  in,  lettering  and  striping  touched  up  and 
varnished.  C,  sash  to  be  removed,  burned  off  and  painted; 
otherwise  same  as  Class  B.  D,  car  to  be  scrubbed  and  var- 
nished. 

Inspection  of  cars  is  made  on  the  road  from  time  to  time, 
and  the  cars  are  brought  in  on  predetermined  dates  as  re- 
quired. When  they  come  into  the  shop  they  are  classified; 
their  trucks  are  taken  off  to  be  taken  to  the  truck  repair 
shop;  any  required  carpenter  work  is  done  on  the  car,  all 
trimmings  are  stripped  off  and  the  sash  and  doors  are  re- 
moved; sashes  needing  repairs  are  taken  to  the  mill  and 
afterwards  painted.  The  cars  are  now  hauled  on  the  shop 
trucks  to  the  paint  shop.  When  the  painting  is  completed  they 
are  returned  to  the  repair  shop  and  mounted  on  their  regular 
trucks  which,  in  the  meantime,  have  been  overhauled  and 
repaired.  Every  large  corporation  follows  some  such  system 
in  maintaining  its  plant  and  equipment,  although  the  system 
is  not  always  so  well  worked  out  as  by  the  Interborough. 
Every  manufacturing  business,  no  matter  how  small,  would 
profit  by  an  imitation  of  the  practice  adopted  by  these 
large  companies  in  the  up-keep  of  their  plant  and  equipment. 

It  is  the  custom  of  those  corporations,  whose  accounting 
methods  are  constructed  along  conservative  lines,  to  charge 
to  maintenance  not  merely  the  cost  of  repairing  the  property, 
but  also  the  cost  of  all  renewals  due  to  breakages  or  failures 
in  service,  and  of  replacements  due  to  the  substitution  of 
some  improved  appliance.  If  the  maintenance  account  were 
strictly  interpreted,  the  difference  between  the  cost  of  new 
rails  or  ties  substituted  for  rails  or  ties  which  are  either 
worn  out  or  inadequate  to  carry  the  strain  of  heavier  cars 
or  engines,  might  be  a  charge  to  capital  account.  The  usual 
practice,  however,  is  to  call   all  such  expenditures  better- 


186  COKPORATION   FINANCE 

ments,  and  either  to  charge  them  direct  to  maintenance  or 
into  some  account,  such  as  extraordinary  expenditure,  cre- 
ated for  the  purpose.  Such  expenditures  should  not  be 
charged  to  capital. 

A  betterment  expense  is  one  which  raises  the  standard  of 
construction.  Examples  of  such  expenditures,  taking  our 
illustration  from  the  railroads,  are  the  substitution  of  stone 
for  gravel  ballast,  and  of  masonry  embankments  or  steel 
structures  for  wooden  trestles,  replacing  light  rail  with 
heavy  rail,  lining  tunnels  with  brick  or  concrete,  substituting 
ties  treated  with  some  preservative  to  prolong  life  for  un- 
treated ties,  fencing  right  of  way,  elevating  tracks  in  cities, 
and  such  like  expenditures  whose  object  is  to  raise  the 
physical  standard  of  the  property.  When  this  new  standard 
has  been  established,  it  is  the  duty  of  the  Maintenance  of 
"Way  Department  to  maintain  it  in  the  same  manner  as  the 
lower  standard  which  it  succeeds. 

These  betterment  expenses,  although  they  represent  an 
increase  in  the  cost  of  the  property,  should  not,  in  the  opinion 
of  most  accounting  officers  of  corporations,  figure  on  the 
balance  sheet  as  an  addition  to  any  asset  account.  It  is 
true  that  they  may  reduce  the  cost  of  operation.  They  may 
even  enable  the  company  to  handle  a  larger  business,  or  to 
handle  its  existing  business  more  expeditiously  and  econom- 
ically. On  the  other  hand,  they  may  do  no  more  than  main- 
tain the  earnings  of  the  company  at  their  former  level.  A 
railroad  company  has  always  to  meet  competition  which  may 
force  it  to  reduce  its  rates,  or  to  improve  the  quality  and 
cost  of  its  service.  The  rates  and  prices  of  all  public  service 
corporations  are  also  liable  to  reduction  by  action  of  the 
legislature  or  some  public  service  commission,  and  the  im- 
provements and  economies  resulting  from  betterment  expenses 
may  be  no  more  than  sufficient  to  offset  the  increased  cost 
in  operation,  due  to  higher  prices  or  higher  wages. 

Former  President  Roberts,  of  the  Pennsylvania  Railroad 
Company,  in  his  report  of  1890,  explained  the  betterment 
policy  of  the  Pennsylvania  Railroad  which  has  always  been 


THE   DETEKMINATION   OF   PEOFITS         187 

to  charge  the  cost  of  such  expenditures  to  "Extraordinary 
Expenditures"  as  follows:  "The  next  item  is  that  of  ex- 
traordinary expenditure  not  properly  chargeable  to  capital 
account,  and  is  one  to  which  attention  has  been  called  by 
our  English  stockholders.  They  claim  that  this  is  a  capital 
expenditure  and  should  not  be  charged  against  the  current 
income ;  it  is  made  up  largely  of  moneys  expended  in  straight- 
ening the  line,  in  improving  the  character  of  the  stations,  in 
providing  additional  track  at  various  points,  in  changing 
iron  bridges  to  stone,  and  wooden  bridges  to  iron,  and  similar 
improvements  that  are  necessary  from  time  to  time  and  that 
are  not  properly  chargeable  to  capital  account,  because  they 
do  not  actually  increase  the  gross  earnings  of  your  property, 
but  simply  maintain  it  in  a  condition  to  effectively  and  eco- 
nomically handle  the  traffic  at  the  low  rates  shown  in  the 
report,  and  enable  it  to  earn  the  interest  on  the  money  pre- 
viously invested." 

President  Koberts  here  shows  why  the  Pennsylvania  could 
not  safely  issue  new  capital  for  the  betterments  which  he 
enumerates.  In  one  period  of  five  years,  from  1898  to  1902, 
the  Pennsylvania  spent  $33,804,000  out  of  earnings  upon 
betterments,  and  yet  the  increase  in  the  balance  to  the  credit 
of  profit  and  loss,  representing  the  additions  to  the  book 
value  of  assets  resulting  from  these  expenditures,  was  only 
$1,919,000.  During  this  period  of  five  years,  $30,885,000 
of  earnings  was  apparently  swallowed  up  in  the  property. 
The  cost  of  these  large  additions  to  the  value  of  productive 
assets  was  charged  to  capital  account,  but  only  in  those 
cases  where  "they  actually  increased  the  earnings  of  the 
property."  These  betterment  expenditures  are  only  indirectly 
and  remotely  productive.  They  are  demanded  by  the  general 
advance  in  railway  practice,  and  they  may  eventually  become 
profitable.  A  conservative  management,  however,  pays  for 
them  out  of  earnings  and  refuses  to  add  their  cost  to  the 
book  value  of  the  assets. 


CHAPTER   XV 
THE  DETERMINATION  OF  PROFITS— DEPRECIATION 

Well-managed  business  enterprises,  and  especially  pub- 
lic corporations  to  whose  standing  and  reputation,  as  already 
explained,  an  accurate  determination  of  their  profits  is  es- 
sential, make  provision  out  of  their  income  for  impairment 
in  the  value  of  their  physical  assets  which  is  known  as 
depreciation.  The  life  of  every  tool,  building,  machine  or 
structure  which  a  company  may  own,  with  the  possible  ex- 
ception of  permanent  structures,  such  as  concrete  bridges, 
wharves,  permanent  roadway,  etc.,  is  limited.  No  matter  how 
carefully  a  machine  may  be  repaired,  no  matter  how  attentive 
the  Equipment  Department  may  be  to  painting  cars  and 
rewinding  armatures,  the  time  finally  comes  when  the  ma- 
chine, or  car,  or  locomotive,  or  building  is  no  longer  fit  for 
use.  Every  piece  of  productive  property,  like  every  normal 
individual,  has  a  period  of  mature  and  vigorous  life  when 
repairs  are  at  a  minimum  and  work  at  a  maximum,  and  a 
period  of  old  age,  finally  ending  in  dissolution.  This  period 
of  useful  service,  in  a  machine  as  in  an  individual,  may  be 
lengthened  by  proper  care.  If  the  individual  does  not  ob- 
serv  the  laws  of  health,  if  he  works  under  unsanitary  con- 
ditions, or  is  subjected  to  excessive  labor,  his  working  life 
is  shortened.  In  the  same  way  unless  the  machine  is  re- 
paired when  out  of  order,  is  sheltered  from  the  weather,  and 
is  saved  from  undue  stresses  and  strains,  the  term  of  its 
active  life  is  reduced. 

The  termination  of  the  active  life  of  a  machine  may  also 
be  due  to  the  discovery  of  some  better  machine  for  doing  the 
188 


THE   DETERMINATION   OF   PROFITS         189 

same  work.  Competition  forces  progressive  business  con- 
cerns to  keep  their  plants  up  to  date  so  that  they  can  produce 
articles  of  good  quality  at  as  low  costs  as  their  competitors. 
A  good  illustration  of  this  class  of  depreciation  which  is 
called  "  Depreciation  due  to  Obsolescence "  is  seen  in  the 
rapid  increase  in  the  size  of  railway  cars.  Within  the  last 
twenty  years,  these  have  increased  from  a  capacity  of  from 
fifteen  to  twenty-five  tons  to  a  maximum  load  of  fifty-five 
tons,  due  largely  to  the  substitution  of  steel  for  wood  in  con- 
struction. This  increase  in  the  size  of  railway  cars  has 
rendered  a  large  number  of  cars  obsolete  before  the  normal 
term  of  their  working  life  has  expired.  The  increase  in  the 
size  and  operative  power  of  the  locomotive  has  had  the  same 
result.  Numbers  of  engines  are  now  doing  good  service  on 
logging  railroads  and  local  lines  which,  without  the  improve- 
ment in  locomotive  construction,  would  still  be  running  on 
the  leading  trunk  lines. 

The  third  cause  of  depreciation  is  changes  in  business 
conditions  which  may  seriously  impair  or  entirely  destroy 
the  productive  value  of  properties  in  perfect  physical  con- 
dition. A  marked  reduction  in  the  tariff  on  the  finer  grades 
of  textiles,  for  example,  would  throw  out  of  use  a  large 
amount  of  perfectly  good  machinery,  and  a  street  railway 
operating  under  a  limited  term  franchise  which  it  carries  on 
its  balance  sheet  as  an  asset,  may  find,  as  in  the  cities  of 
Cleveland  and  Chicago,  that  the  value  of  this  asset  is  de- 
stroyed or  greatly  impaired  by  a  change  in  public  sentiment 
imposing  additional  burdens  and  restrictions  upon  street-rail- 
way companies. 

Understanding  now  the  regular  and  inevitable,  as  well 
as  the  accidental  and  contingent  reductions  in  the  value  of 
a  company's  productive  property,  we  can  recognize  the  neces- 
sity of  providing  in  advance  for  its  replacement.  In  so  far 
as  these  losses  can  be  estimated  with  approximate  exactness, 
an  accurate  provision  can  be  made.  Contingent  and  extra- 
ordinary losses,  however,  can  only  be  anticipated  by  provid- 
ing such  sums  as  experience  shows  will  probably  be  sufficient 


190  •    COEPOKATION   FINANCE 

to  offset  these  losses,  and  there  still  remain  the  losses  due  to 
such  causes  as  change  in  fashion  or  in  the  tariff,  against  which 
no  foresight  can  provide  because  there  is  no  method  of  prede- 
termining the  amount  of  the  damage. 

The  losses  due  to  depreciation,  if  provision  is  not  made 
to  apportion  them  over  a  series  of  years,  may  fall  upon  a 
business  with  such  force  as  to  annihilate  it.  When  a  plant 
is  new,  repairs  are  light  and  replacements  are  not  necessary. 
This  condition  may  persist  for  several  years.  In  the  mean- 
time the  management,  not  convinced  of  the  necessity  of  mak- 
ing provision  against  the  day  when  their  plant  shall  be  worn 
out,  may  have  paid  out  all  their  earnings  to  their  stock- 
holders. At  the  end  of  the  fifth  or  sixth  year  extensive 
renewals  become  necessary,  machines  are  worn  out  or  become 
obsolete;  and  a  reconstruction,  a  rearrangement,  or  a  reloca- 
tion of  the  plant  may  be  necessary.  If  money  is  not  avail- 
able for  these  purposes,  all  that  the  management  can  do  is 
to  issue  stock  or  bonds  and  spend  the  proceeds,  not  in  increas- 
ing the  value  of  their  property,  but  merely  in  maintaining  it 
at  its  original  figure. 

An  illustration  on  a  small  scale  will  serve:  A  man  ob- 
tained a  pumping  contract  from  a  railroad.  The  contract 
ran  for  ten  years  and  called  for  a  payment  of  $2,000  a  year. 
The  cost  of  the  pump  and  other  machinery  was  $5,000  and 
the  operating  expenses  $1,000  each  year.  The  owner  gave 
but  nominal  supervision  to  the  plant,  which  indeed  was  all 
that  it  required,  and  estimated  his  profits  at  $1,000  a  year 
or  $10,000  during  the  life  of  the  contract.  At  the  end  of 
the  time,  however,  when  the  contract  came  to  be  renewed, 
it  was  found  that  the  pump  was  worn  out,  the  $5,000  invested 
had  been  lost,  and  it  was  necessary  for  the  contractor  to 
raise  another  $5,000  for  the  purchase  of  new  apparatus.  In- 
stead of  a  profit  of  $10,000  during  the  ten  years,  the  actual 
profits  of  the  business  were  only  $5,000.  A  correct  account- 
ing system  would  have  required  the  setting  aside  of  $5,000 
in  such  a  form  as  to  be  available  at  the  end  of  ten  years  for 
the  purchase  of  a  new  pump. 


THE   DETERMINATION   OF   PROFITS  191 

The  accounting  for  depreciation  is  managed  by  building 
up  in  the  assets  of  the  business  an  amount  of  value.  Provi- 
sion for  depreciation  is  made  as  follows:  A  deduction  is 
made  from  income  of  the  amount  estimated  to  be  necessary 
in  that  year  to  provide  for  depreciation.  This  amount  is 
kept  in  the  business,  either  being  held  as  a  bank  deposit, 
invested  in  securities,  or  spent  in  such  a  way  as  to  increase 
the  value  of  the  company's  property,  for  example,  upon  a 
new  mill  or  a  new  piece  of  machinery.  If  an  expenditure 
is  made,  cash  is  credited,  and  machinery  or  plant  account, 
or  the  materials  or  securities  purchased  is  debited.  Then 
Profit  and  Loss  is  debited  and  depreciation  reserve,  appear- 
ing as  a  liability  on  the  balance  sheet,  is  credited.  This  plan 
is  followed  year  by  year,  until  a  depreciation  reserve  of  large 
amount  may  be  built  up  as  a  liability  to  the  business,  balanced 
by  various  assets  on  which  a  certain  amount  of  the  income 
of  the  company  has  been  spent. 

Now  suppose  that,  after  a  term  of  years,  since  deprecia- 
tion does  not  usually  count  in  the  early  stages  of  a  company's 
operations,  new  equipment  is  necessary  to  replace  that  which 
is  unfit  for  service,  or  that  a  complete  overhauling,  a  reloca- 
tion, or  a  reconstruction  of  the  plant  is  necessary,  including 
a  general  replacement  of  its  machinery  with  machinery  of 
new  and  improved  design.  The  cost  of  the  reconstruction 
or  replacement  is  provided  either  out  of  the  income  of  the 
company  or  by  an  increase  of  its  bonds  or  stock.  The  entries 
are  as  follows:  in  case  provision  is  made  out  of  the  cur- 
rent income  of  the  year  for  necessary  depreciation;  cash 
is  credited  and  the  plant  account  concerned  is  debited; 
then  depreciation  reserve  is  debited  and  plant  account  is 
credited  for  the  equipment  thrown  out.  If  the  old  ma- 
chinery can  be  sold,  cash  is  debited  and  the  depreciation 
reserve  is  credited.  If  the  cost  of  replacement  is  too  large 
to  be  thrown  upon  the  income  of  a  single  year,  provision 
for  the  expense  is  made  in  the  following  manner:  The 
company,  we  will  suppose,  presents  the  following  balance 
sheet : 


192  COKPORATION   FINANCE 

Assets  Liabilities 

Plant  and  equipment. .  $2,000,000     Stock $1,000,000 

Cash  and  current  as-                       Bonds 500,000 

sets 500,000    Depreciation  reserve .  .  500,000 

Surplus 500,000 

$2,500,000  $2,500,000 

Suppose  that  $500,000  is  required  for  extensive  replacements 
and  reconstruction,  and  that  only  $200,000  of  this  amount 
can  be  provided  out  of  the  income  of  that  year.  Eesort  is 
now  had  to  the  depreciation  reserve,  the  accumulations  of 
past  investments  for  the  benefit  of  the  depreciation  fund. 
The  company  issued  $300,000  of  bonds,  increasing  its  bonded 
debt  to  $800,000  and  reducing  the  depreciation  reserve  by 
a  corresponding  amount.  The  proceeds  of  the  bonds  to- 
gether with  the  $200,000  taken  from  income  are  spent  in 
renewing  the  plant.  After  this  operation  is  completed,  the 
balance  sheet  is  as  follows: 

Assets  Liabilities 

Plant $2,000,000    Stock $1,000,000 

Cash  and  current  as-                        Bonds 800,000 

sets 500,000     Depreciation  reserve .  .  200,000 

Surplus 500,000 

$2,500,000  $2,500,000 

What  has  been  done  is  to  substitute  on  the  balance  sheet  one 
kind  of  liability  for  another,  reducing  the  depreciation  reserve 
and  increasing  the  amount  of  bonds,  leaving  the  surplus,  the 
difference  between  assets  and  liabilities,  at  its  former  figure. 
Speaking  in  terms  of  capitalization,  the  company  has  cap- 
ital Lzed  a  portion  of  its  surplus  assets  for  the  sake  of  obtain- 
ing funds  to  renew  its  plant. 

The  accumulated  reservations  for  depreciation  may  be 
disposed  of  in  two  ways:  First,  they  may  be  handled  as  a 
fund  and  kept  in  assets  which  are  either  specifically  set  aside 
for  the  purpose  of  making  renewals,  when  these  shall  become 
necessary,  or  kept  in  the  current  assets  of  the  business  im- 
mediately available  for  use.    This  is  the  method  adopted  by 


THE   DETERMINATION   OF   PROFITS  193 

the  United  States  Steel  Corporation.  The  balances  to  the 
credit  of  sinking,  depreciation  and  extraordinary  replacement 
and  improvement  funds,  which  are  all  treated  alike,  on 
December  31,  1908,  were  included  in  the  assets  of  the  com- 
pany in  the  following  accounts: 

Sundry  securities  at  cost $6,793,413.81 

Cash 6,475,840.47 

Invested  in  Tennessee  coa),  iron  and  railway  company 

stock 4,222,537. 11 

In  marketable  securities  at  market  value 723,380 .  34 

In  cash,  special  deposit 757,500 .  00 

In  current  assets: 

Cash,  loans,  receivables,  inventories,  etc 23,573,641 .94 

$42,546,313.67 

This  total  was  arrived  at  as  follows :  The  balances  to  the 
credit  of  these  various  funds  aggregated  on  December  31, 
1907,  $41,360,655.19.  During  the  year  1908,  there  was  set 
aside  from  income  and  by  charges  to  current  expenses  $22,- 
474,395.26,  and  other  income  and  credits  to  the  various  funds 
brought  up  the  total  to  $64,984,789.98.  The  amounts  charged 
to  the  various  funds  during  the  year  aggregate  $22,438,- 
476.31,  leaving  a  balance  as  already  stated,  of  $42,5^6,313.67. 
The  United  States  Steel  Corporation  keeps  its  depreciation 
and  other  funds  in  a  form  readily  available  for  use,  invested 
in  the  current  assets  of  its  business  as  a  part  of  its  working 
capital.  If  the  directors  should  conclude  that  a  more  definite 
separation  of  the  assets  representing  these  various  funds 
should  be  made,  they  could  make  a  special  deposit  of  all  the 
money,  or  invest  it  in  securities  which  could  be  used  for 
nothing  else  than  to  provide  means  for  the  replacement  and 
renewals  as  required. 

The  International  Harvester  Company  handles  its  depre- 
ciation account  in  a  different  manner.  The  accumulations  in 
the  plant  depreciation  and  extinguishment  funds  of  this  com- 
pany on  December  31,  1908,  amounted  to  $5,009,844.  This 
amount  appears  on  the  balance  sheet  as  a  liability  item  under 
the  head  of  "Provisional  and  Contingent  Reserves."  The 
total  amount  of  these  reserves  at  this  date  was  $6,850,590.37. 


194  CORPOKATION   FINANCE 

In  addition,  the  company  had  a  surplus  of  $16,691,989.61; 
the  two  amounts  together  being  $23,542,579.98.  This  sum 
represented  the  difference  between  assets  and  liabilities  ac- 
cumulated out  of  the  profits  of  the  business  from  the  date 
of  its  organization.  This  accumulation  was  in  part  the  result 
of  increase  in  property  account,  in  part  the  result  of  the 
payment  of  liabilities  of  which  $3,173,398.21  under  the  head 
of  "  Purchase  money  obligations  '^  were  discharged  in  1908, 
and  in  part  of  an  increase  in  current  assets.  There  is  no 
attempt  made  by  this  company,  so  far  as  appears  in  its 
report,  to  keep  its  depreciation  fund  in  any  particular  form 
of  assets.  As  the  money  is  reserved,  it  is  apparently  put  to 
the  most  advantageous  use,  either  in  increasing  the  bank 
balances  of  the  company  or  its  stocks  of  railway  materials, 
or  in  paying  its  debts,  or  in  additions  and  improvements  to 
its  plant.  The  depreciation  fund  of  the  International  Har- 
vester Company  is  represented  by  amounts  invested  in  dif- 
ferent productive  assets  of  the  company  without  special  segre- 
gation. 

This  method  is  the  one  ordinarily  followed.  Its  general 
adoption  by  those  companies  which  maintain  depreciation 
funds  has  given  rise  to  the  statement  often  heard,  that  a 
depreciation  reserve  is  only  a  bookkeeping  item  without  spe- 
cial significance.  There  is  no  fundamental  distinction  be- 
tween the  surplus  appearing  on  the  balance  sheet  and  the 
depreciation  reserve  also  appearing  as  a  liability.  Added 
together,  they  represent  the  total  accumulations  out  of  in- 
come which  are  held  in  the  business  for  the  benefit  of  the 
business.  The  only  difference  between  the  surplus  and  the 
dej  L-eciation  reserve  lies  in  the  fact  that  the  former  is  usu- 
ally regarded  as  the  property  of  the  stockholders  to  be  dis- 
tributed to  them,  from  time  to  time,  by  various  adjustments 
of  capitalization,  which  will  be  considered  in  detail  in  a  later 
chapter,  while  the  depreciation  reserve  is  regarded  as  some- 
thing belonging  to  the  business,  which  is  to  be  withheld  from 
the  stockholders  to  make  good  any  extraordinary  replace- 
ments or  renewals  for  which  the  current  reservations  from 


THE   DETEEMINATION   OF   PROFITS  195 

income  for  the  purposes  of  depreciation  will  not  prove 
adequate. 

There  is,  of  course,  a  limit  beyond  which  it  is  unprofitable 
for  a  company  to  accumulate  a  fund  of  this  character.  When 
the  amount  of  the  depreciation  reserve  fund  has  reached  be- 
yond the  figure  which  in  the  judgment  of  the  directors  is 
necessary  to  protect  the  business  against  extraordinary  acci- 
dents, it  can  then  be  treated  as  a  part  of  the  surplus  and 
distributed  to  the  stockholders.  As  an  example  of  such  a 
distribution,  the  stock  dividend  of  the  Pullman  Company, 
voted  on  February  10,  1910,  was  explained  by  the  directors 
in  part  as  follows:  "There  were  certain  reserve  accounts  in 
the  manufacturing  department  which  had  hitherto  been  held 
in  abeyance  to  meet  contingencies  which  were  possible  to 
arise  (fire  insurance),  but  which  present  conditions  render 
improbable.  These  items,  together  with  the  existing  surplus 
as  shown  in  the  published  statement  of  the  last  fiscal  year 
and  the  current  results  of  operation,  are  regarded  by  the 
board  as  a  justification  for  making  this  recommendation." 
The  Pullman  Company,  in  making  these  dividends,  trans- 
ferred certain  of  its  reserves  to  its  surplus  account,  and  then 
substituted  for  a  portion  of  the  surplus  an  equal  amount 
of  capital  stock. 

The  balance  sheets  of  conservatively  managed  companies 
may  show  reserves  in  addition  to  the  depreciation  reserve. 
Thus  the  International  Harvester  Company  maintains  a  re- 
serve for  collection  expenses  and  receivables  to  provide  for 
losses  which  may  ultimately  be  sustained  in  the  reialization  of 
bills  and  accounts  receivable,  and  a  cash  reserve  when  it  is 
deemed  wise  for  a  company  to  carry  its  own  insurance.  A 
company  may  also  maintain  a  dividend  reserve  fund  to  make 
good  any  temporary  shortages  in  income  available  for  distri- 
bution to  stockholders.  These  reserves  are  built  up  out  of  the 
unexpended  balances  of  the  annual  appropriations  to  these 
several  purposes.  For  example,  the  International  Harvester 
Company  provided  for  contingent  losses  on  receivables  in  1908, 
$650,000.    The  debts  which  were  charged  off  as  uncollectable 


196  CORPORATION  FINANCE 

during  1908  amounted  to  only  $228,048.15,  so  that  there  was 
an  addition  to  the  reserve  for  contingent  losses  on  receivables 
during  the  year  of  $421,951,85.  The  efforts  of  this  company 
are  constantly  directed  toward  reducing  the  losses  against 
which  these  reserves  are  established  to  provide.  It  has  spent 
large  sums  to  equip  its  works  and  other  buildings  with  auto- 
mobile sprinkling  systems  and  the  latest  devices  for  protec- 
tion against  fire,  and  it  carries  on  continually  a  systematic 
investigation  into  the  financial  responsibility  of  prospective 
customers  who  give  notes  for  purchases.  This  insures  to 
the  company  a  high  grade  of  notes  and  accounts.  These 
precautions,  and  the  care  taken  to  reduce  losses,  tend  to 
increase  the  balances  annually  added  to  these  various  funds 
which  may  in  time  be  carried  to  such  a  height  that  a  por- 
tion of  them  can  be-  distributed  to  stockholders. 

These  reserves  are  handled  in  the  same  manner  as  the 
reserve  for  plant  depreciation,  with  the  exception  that  the 
insurance  reserves  and  the  dividend  reserves,  in  order  to  be 
immediately  available  for  use,  should  be  invested  in  good 
securities  set  aside  for  the  purposes  of  these  funds.  As  an 
illustration  of  this  segregation,  we  find  that  the  balance  in 
the  fire  insurance  reserve  of  the  International  Harvester 
Company  of  December  31,  1908,  was  $671,093.23,  of  which 
$400,832.20  had  been  invested  in  income-bearing  securities 
on  that  date.  Since  that  date  the  balance  of  the  fund  has 
also  been  invested  in  income-bearing  securities. 

In  calculating  depreciation,  the  first  step  is  to  determine 
the  amount  necessary.  This  is  figured  as  a  percentage  of 
the  cost  of  property  to  be  depreciated.  The  percentage  is 
obtained  by  estimating,  sometimes  in  great  detail,  the  active 
life  of  different  kinds  of  equipment  and  dividing  the  result 
into  100  to  obtain  the  annual  rate  of  depreciation.  By  the 
method  ordinarily  followed,  no  account  is  taken  of  compound 
interest.  If  a  business  or  property  is  estimated  to  last  for 
twenty  years,  five  per  cent  of  this  cost  is  assumed  to  be 
reserved  out  of  income  in  each  year  in  order  to  make  good 
the  annual  depreciation.    The  Chicago  Union  Traction  Com- 


THE   DETERMINATION    OF   PROFITS  197 

pany,  for  example,  has  adopted  the  following  rates  for  its 
power-plant  equipment: 

Life  Rate 

Track,  ties,  bonding,  etc 12. 85 years;  7.75% 

Paving  and  grading: 

Granite  block 16  "  6.6% 

Cobblestone 25  "  4% 

Electric  equipment  of  cars 12-15      "  8.5%  to  6^% 

Iron  poles 20  "  5% 

Power-plant  equipment 15  "  6.66% 

Shop  tools  and  machinery 20  "  5% 

Buildings  and  improvements 50  "  2% 

These  various  percentages  are  applied  to  the  costs  of  the 
equipment,  and  the  results  added  together  are  assumed  to 
give  the  annual  requirement  for  depreciation  for  that  year. 
These  rates,  however,  are  subject  to  wide  variations  un- 
der different  conditions.  Mr.  C.  I.  Sturgis  ^  explains  these 
variations  in  relation  to  railway  equipment  as  follows: 

On  a  railroad,  the  life  of  ties  varies  with  soil 
and  climate ;  the  life  of  bridges  depends  on  the  weight 
of  locomotives  running  over  them;  the  life  of  loco- 
motives depends  on  the  quality  of  water  and  coal 
with  which  they  are  fed,  and  there  is  hardly  a  rail- 
road tool  or  machine  the  life  of  which  does  not  depend 
on  local  conditions,  and  even  if,  in  determining  de- 
preciation, we  could  approximately  estimate  such  vari- 
able factors  as  these,  we  would  still  have  to  consider 
what  in  the  end  will  be  the  cost  of  the  new  articles 
to  replace  the  old,  and  with  markets  ever  fluctuating 
that  is  impossible  definitely  to  determine.  Further- 
more, prosperous  roads,  in  maintaining  high  stand- 
ards, consider  equipment  is  worn  out  when,  on  poorer 
roads,  it  would  be  considered  still  good  for  many  years 
of  service. 

While  admitting  the  influence  of  local  conditions  upon 
assumed  rates  of  depreciation,  it  is  possible  to  give  proper 
weight  to  these  influences  on  the  basis  of  experience  in  that 
locality,  and  to  ascertain,  with  a  degree  of  accuracy,  the  life 

1  Electric  Railway  Journal,  December  18, 1909. 
14 


198  COEPORATION  FINANCE 

of  the  company's  property.  It  is  also  possible  to  ascertain, 
as  we  have  explained  in  our  discussion  of  maintenance,  the 
effect  of  high  and  low  standards  of  maintenance  on  depre- 
ciation. Property  which  is  well  maintained  will  last  much 
longer,  and  give  more  effective  service  during  its  life,  than 
where  maintenance  is  neglected.  We  may  conclude,  there- 
fore, that  depreciation  due  to  wear  and  tear  and  to  natural 
decay  can  be  closely  approximated. 

Depreciation  due  to  obsolescence  and  extraordinary  acci- 
dents involving  extensive  expenditures  upon  the  plant  can- 
not be  estimated  even  approximately.  A  case  came  recently 
to  the  writer's  notice  where  the  owner  of  a  textile  mill  had' 
imported  an  expensive  machine  from  England  and  estimated 
that  it  would  last  only  five  years.  He  therefore  assigned  to 
it  a  depreciation  rate  of  twenty  per  cent.  Within  two  years, 
however,  this  machine  was  displaced  by  a  better  one,  so  that 
the  correct  rate  should  have  been  fifty  per  cent.  Other  illus- 
trations are  the  passage  of  city  ordinances  requiring  large 
expenditures  on  track  elevation  or  an  electrification  to  abol- 
ish the  smoke  nuisance.  Such  changes  as  this  cannot  be 
foreseen.  It  is  impossible  to  provide  against  them.  Partial 
provision,  it  is  true,  may  be  made  in  the  manner  already 
indicated  by  establishing  various  rates  of  depreciation  and, 
by  improving  the  business  methods  of  the  concern,  accumu- 
lating reserves  against  various  contingencies.  These  reserves 
are  available  for  emergencies.  But  even  the  most  conserva- 
tive company  cannot  make  suitable  provision  out  of  its  income 
accounts  to  protect  it  against  any  contingency  which  might 
arise.  For  example,  depreciation  on  telephone  equipment 
can  be  figured  at  ten  per  cent  per  annum.  This  will  pro- 
vide for  the  replacement  of  the  plant  at  the  end  of  ten 
years.  But  suppose  the  town  is  visited  by  a  hurricane  and 
most  of  the  plant  is  destroyed.  This  would  be  a  contingency 
against  which  no  foresight  consistent  with  ordinary  business 
practice  would  provide.  All  that  can  be  done  in  the  event 
of  such  a  catastrophe  is  for  the  owners  of  the  business  to 
take  their  loss  and  build  anew,  increasing  their  toll  rates. 


THE   DETEEMINATION   OF   PKOFITS  199 

if  need   be,   in   order  to   regain   the  money   spent  for   the 
reconstruction  of  the  plant. 

As  an  offset  to  this  sort  of  depreciation,  several  account- 
ants and  engineers  have  urged  the  natural  appreciation  in 
the  value  of  the  property  due  to  the  development  of  its 
business.  This  phase  of  depreciation  accounting  is  discussed 
by  Mr.  Frederic  A.  Delano,  president  of  the  Wabash  Rail- 
road,^ as  follows: 

In  most  cases  the  depreciation  due  to  the  diminished 
value  of  equipment,  track,  bridges,  structures  of  all 
kinds,  shops  and  shop  tools  already  referred  to,  is 
limited,  as  has  been  explained,  and  is,  furthermore,  a 
good  deal  more  than  counterbalanced  by  the  appre- 
ciation due  to  the  fact  that  the  age  of  the  railroad 
has  given  it  an  established  business.  This  amounts  to 
a  good  deal  more  in  the  case  of  a  railroad  than  what 
is  called  "  good  will "  in  the  case  of  a  mercantile 
corporation.  As  a  railroad  is  developed,  industries,  , 
mines,  factories,  etc.,  are  established  along  its  tracks, 
with  switches  and  side  track  facilities,  towns  grow 
up  along  it,  and  a  certain  amount  of  business  becomes 
assured  to  it — business  which  it  takes  years  and  a 
large  expenditure  of  money  and  energy  to  develop — 
all  of  which  is  charged  into  current  operating  expenses 
and  should  be  considered  as  an  offset  to  any  depre- 
ciation of  the  property. 

Besides  the  appreciation  due  to  this  cause  there  is, 
of  course,  an  actual  physical  enhancement  of  value  due 
to  the  condition  of  the  roadbed  and  embankments  be- 
coming better  solidified,  the  water  courses  established 
and  the  original  structures  gradually  replaced  with 
others  of  a  more  permanent  character,  even  without 
any  addition  to  capital  account;  thus  wooden  trestles, 
bridges,  culverts,  etc.,  have  been  filled  with  earth  or 
replaced  by  steel  or  iron,  stone  or  concrete. 

No  account  is  taken  and  no  estimate  can  be  made  of 
the  enhanced  value  of  the  railroad  property  (right  of 
way  and  terminals)  due  to  the  enhanced  value  of 
the  land,  even  though  the  existence  of  the  railroad 


Railway  Age  Gazette,  March  27,  1908. 


200  COKPOKATION   FINANCE 

may  have  contributed  largely  to  the  development  of 
the  country  through  which  it  runs.  The  railroad  cor- 
poration suffers  by  reason  of  this  enhanced  value 
which  it  has  so  largely  contributed  to  create  if  it  is 
compelled  to  purchase  any  additional  property,  as  well 
as  in  the  increased  amount  of  the  taxes  it  is  called 
upon  to  pay  each  year  as  its  contribution  to  the  needs 
of  the  growing  communities;  but  it  has  not  been  usual 
to  make  any  allowance  for  this.  Those  who  have  had 
the  greatest  experience  with  railways  generally  be- 
lieve that  the  enhancement  in  value  or  appreciation 
of  the  property  in  the  direction  already  referred  to 
far  more  than  balances  the  depreciation,  especially 
when  it  is  remembered  that  the  total  physical  depre- 
ciation, under  proper  maintenance  rules,  is,  without 
doubt,  limited  to  about  haK  the  first  cost  of  the  prop- 
erty subject  to  depreciation. 

The  considerations  advanced  by  President  Delano  should 
be  taken  into  account  in  estimating  depreciation  rates.  In 
the  writer's  opinion,  it  is  unsafe  to  go  so  far  as  he  does  in 
claiming  that  appreciation  offsets  all  depreciation.  This  en- 
hancement in  the  value  of  a  business  is  dependent  to  a  large 
extent  upon  the  conditions  of  trade.  Certainly,  from  1892 
to  1897,  there  was  no  appreciation  in  the  value  of  railway 
property  in  the  United  States.  At  this  time  a  large  amount 
of  railway  mileage  was  in  the  hands  of  receivers,  and  railway 
earnings  were  greatly  depressed.  It  is  true,  however,  that 
under  ordinary  conditions  the  appreciation  to  which  the  pres- 
ident of  the  Wabash  refers  is  present  in  every  well-managed 
concern;  and,  while  it  does  not  seem  wise  to  take  it  into 
account  as  offsetting  depreciation  due  to  use,  it  will  go  far 
to  offset  depreciation  due  to  obsolescence  and  extraordinary 
accidents. 

In  final  summary  of  the  rules  for  establishing  rates  of 
depreciation,  the  following  may  be  taken  as  conservative: 
First,  charge  to  maintenance  the  cost  of  all  replacements,  even 
when  the  cost  of  the  property  substituted  for  that  worn  out  or 
displaced  by  a  better  machine  is  greater  than  that  originally 


THE   DETERMINATION   OF  PROFITS  201 

purchased;  second,  maintain  depreciation  rates  based  on 
standards  established  by  engineers  familiar  with  the  business 
in  which  the  corporation  is  engaged,  and  after  making  due 
allowance  for  special  and  local  conditions;  third,  provide  ad- 
ditional reserves  for  special  classes  of  losses  not  covered  by 
outside  insurance. 

Our  final  topic  for  discussion  under  the  head  of  depre- 
ciation concerns  the  comparison  between  sinking  funds  and 
depreciation.  There  is  substantial  identity  between  these 
two  classes  of  deductions  from  income.  The  sinking  fund, 
whether  maintained  against  so-called  "  wasting  "  assets — that 
is,  coal  or  ore — or  against  the  plant  of  an  electric  railway, 
or  the  terminable  franchise  of  a  public  service  corporation, 
up  to  the  percentage  of  the  total  cost  of  the  company's 
assets  which  is  represented  by  its  bonds,  and  up  to  the  per- 
centage of  the  cost  of  the  property  which  is  represented  by 
the  annual  appropriations  for  the  sinking  fund,  is  usually 
regarded  as  the  identical  equivalent  of  a  depreciation  charge. 
If  the  entire  property  of  a  company  is  represented  by  its 
bonds,  which  often  happens,  and  if  its  life  is  twenty  years, 
a  sinking  fund  of  five  per  cent  on  the  bonds  is  the  same 
as  a  depreciation  of  five  per  cent  on  the  cost  of  the  property. 
At  the  end  of  the  twenty  years,  the  plant  is  worn  out,  the 
bonds  are  paid,  and  the  company  is  back  where  it  started, 
with  the  addition  of  the  good  will  and  prestige  which  it  has 
accumulated.  It  can  then  incur  a  new  debt  for  the  original 
amount,  probably  at  a  lower  rate  of  interest,  rebuild  its 
plant,  and  maintain  its  surplus  intact. 

The  identity  of  the  sinking  fund  and  the  depreciation 
charge  may  be  admitted,  however,  only  with  important  quali- 
fications. The  depreciation  fund  should  be  available  for  re- 
placements when  these  are  required.  When  a  sinking  fund 
is  invested  in  bonds,  whether  these  are  canceled  or  held,  it 
is  not  available  for  current  replacements,  but  only  for  ex- 
tinguishment of  the  company's  Mt  The  later  forms  of 
sinking  fund,  however,  contain,  as  noted  in  a  former  chapter, 
certain  provisions  which  remove  the  foregoing  objection  to 


202  COKPOKATION   FINANCE 

identifying  a  sinking  fund  with  a  depreciation  charge.  If 
the  bonds  purchased  for  the  sinking  fund  can  be  reissued 
to  provide  funds  for  improvements  and  extensions,  or  if  the 
sinking  fund  can  be  invested  in  the  plant  at  the  option  of  the 
trustee,  the  sinking  fund  and  the  depreciation  charges  are 
in  all  particulars  the  same,  and  the  amount  of  the  sinking 
fund  established  should  be  deducted  from  the  assumed  rate 
of  depreciation.  If  the  company  maintains  a  sinking  fund 
against  its  debt,  and  also  allows  rates  of  depreciation  on  the 
cost  of  its  physical  property,  it  is,  to  the  extent  of  the  sink- 
ing fund,  duplicating  its  depreciation  charge,  and  accumu- 
lating reserves  in  its  asset  accounts  which  will  eventually 
come  to  the  stockholders,  or  which  may  be  drawn  out  in 
case  of  emergency. 

After  ascertaining  the  total  income  of  the  company,  con- 
sisting of  net  earnings  from  operation  plus  other  income, 
certain  deductions  must  be  made  known  as  fixed  charges, 
which  include  taxes,  interest,  and  rental.  The  only  question 
which  may  arise  concerning  these  payments  is  the  treatment 
of  interest  paid  on  bonds  during  the  construction  period.  It 
is  customary  to  include  this  in  the  construction  cost,  issuing 
enough  securities  not  only  to  provide  for  the  cost  of  the 
plant,  but  to  pay  interest  on  the  bonds  while  the  plant  is 
building.  As  long  as  no  secret  is  made  of  the  matter,  and 
it  is  well  understood,  there  can  be  no  reasonable  objection 
to  the  practice.  All  that  could  be  required  is  for  the  stock- 
holders to  advance  the  money  necessary  to  pay  interest  on 
bonds  during  the  construction  period. 

The  final  item  of  charges  consists  of  such  miscellaneous 
iteirs  as  commissions  on  sales  of  securities  and  other  ex- 
penses which  are  chargeable  against  income,  but  which  can- 
not properly  be  classified  either  as  operating  expenses  or  as 
fixed  charges.  Companies  often  include  as  "other  charges" 
the  cost  of  betterments  and  additions  which,  in  the  judgment 
of  the  directors,  are  not  properly  chargeable  to  capital  ac- 
count. This  has  been  discussed  in  connection  with  deprecia- 
tion.   Such  expenditures  should  be  charged  to  operating  ex- 


THE  DETEKMINATION   OF   PROFITS  203 

pense  rather  than  to  fixed  charges.  The  balance  remaining 
after  these  charges  have  been  paid  is  the  surplus  earned  for 
the  stock  during  the  year,  out  of  which  dividends  may  be 
paid.  Another  source  of  surplus  consists  of  profits  from  pre- 
miums on  the  sales  of  securities  issued  by  the  company.  Dis- 
counts on  all  sales  of  securities  are  to  be  considered  as 
losses  and  charged  against  the  income  of  the  year.  For  the 
same  reason,  premiums  received  are  to  be  regarded  as  profit. 
The  next  item  in  the  income  account  is  income  from 
other  sources.     This  is  made  as  follows: 

Interest  received  on  bonds  of  others  companies; 

Dividends  on  stocks  of  other  companies; 

Rentals  of  property  owned  by  the  company  and 
leased  to  outsiders; 

Interest  on  the  company's  bank  deposits  or  on  any 
loans  in  which  it  may  invest  its  cash  balance. 

These  receipts  are  usually  incidental  to  the  main  operations 
of  the  company. 

Business  corporations  are  not  primarily  investment  com- 
panies. They  are  organized  to  transact  a  railroad  or  manu- 
facturing or  trading  business;  and,  although  they  may  ac- 
quire securities  in  the  course  of  their  regular  business,  these 
securities  are  usually  acquired  for  other  purposes  than  to 
obtain  revenue.  A  railroad  corporation,  for  example,  may 
purchase  an  interest  in  the  stock  of  another  company  with 
which  it  exchanges  a  large  amount  of  traffic,  and  may  re- 
ceive a  dividend  on  this  stock.  The  principal  advantage  of 
the  purchase  is  not,  however,  to  receive  the  dividend,  but 
to  obtain  a  favorable  traffic  agreement. 

Again,  railroad  companies  may  build  new  mileage  through 
subsidiary  companies  to  which  they  advance  money,  taking 
the  bonds  and  stocks  of  the  subsidiary  companies  as  payment 
and  holding  these  in  their  treasury.  In  this  case,  instead  of 
treating  the  operations  of  all  the  companies  under  their  con- 
trol as  a  unit,  we  have  the  distinction  between  lines  directly 
operated  and  lines  controlled.     In  reality,  however,  the  re- 


204  COEPORATION   FINANCE 

turns  on  the  stocks  and  bonds  of  the  subsidiary,  while  in 
the  treasury  of  the  parent  company,  represent  merely  a  part 
of  the  operating  income  of  the  entire  system. 

The  item  of  interest  on  bank  deposits  figures  largely  in 
the  accounts  of  profitable  corporations  during  periods  when 
they  are  not  expanding  their  operations,  especially  when  their 
receipts  are  evenly  distributed  throughout  the  year,  and  their 
dividend  and  interest  payments  are  made  at  periodical  in- 
tervals. Under  these  circumstances,  there  is  necessarily  a 
considerable  accumulation  of  money  to  the  credit  of  the 
company,  and  this  money  they  may  either  leave  on  deposit, 
receiving  the  bank  rate  of  interest,  or  they  may  lend  it  out 
at  a  higher  return  than  the  banks  will  pay.  During  periods 
of  great  business  activity,  however,  this  source  of  income  is 
ordinarily  not  available,  since  the  corporation  needs  all  of  its 
money  to  conduct  its  regular  operations,  and  is  usually  a 
heavy  borrower  besides. 

Profits  from  premiums  on  securities  sold  are  essentially 
different  from  profits  or  losses  derived  from  income  account. 
When  securities  of  a  company  are  sold  at  a  premium,  the 
usual  practice  is  to  show  in  the  balance  sheet  as  a  capital 
liability  only  the  par  value  of  the  security  sold,  and  to  credit 
to  surplus,  or  profit  and  loss  account,  the  premium  received 
above  the  par  value.  Profits  derived  from  the  sale  of  capital 
obligations  should  be  reserved  as  capital,  unless  the  company 
is  dissolved,  and  should  be  separately  stated  in  the  balance 
sheet. 

In  practice,  this  separate  statement  of  premiums  on  sales 
of  securities  is  rarely  made.  The  consequence  is  that  di- 
rectors may  get  a  wrong  idea  of  the  profits  of  the  business, 
and  may  pay  dividends  which  are  not  warranted  by  the  earn- 
ings from  operation.  The  practice  of  investing  these  pre- 
miums in  productive  assets  is,  however,  so  well  established 
that  the  danger  of  basing  dividends  upon  them  is  remote. 
A  similar  disposition  is  usually  made  of  profits  received  from 
the  sale  of  unpledged  treasury  assets,  usually  consisting  of 
securities.    Unless  the  total  proceeds  are  distributed  to  stock- 


THE   DETERMINATION   OF   PROFITS  205 

holders  as  a  special  dividend,  the  practice  is  to  invest  the 
entire  proceeds  in  the  improvements  in  capital  assets.  Such 
a  disposition  was  made  by  the  Pennsylvania  of  the  proceeds 
of  the  sale  of  the  coal  stocks  following  the  passage  of  the 
Hepburn  Law  in  1906.  A  large  profit  was  shown,  but  the 
entire  proceeds  were  invested  in  the  property. 

Discounts  on  securities  sold  are  treated  as  losses.  If  small 
in  amount,  they  are  charged  against  the  income  of  the  year. 
Discounts  on  bonds  or  stock  sold  at  the  outset  for  original 
construction  are  usually  included  in  the  cost  of  construc- 
tion. 

The  third  source  of  surplus  is  "  profits  and  losses  from 
the  sale  of  assets."  A  company  may  have  operated  a  factory 
situated  in  a  large  city  where  land  values  were  steadily  ap- 
preciating. In  time,  the  growth  of  the  company's  operations 
make  a  country  location  desirable.  The  city  reaj  estate  then 
comes  up  to  be  sold,  and  it  is  found  that  its  value  is  greatly 
increased  over  its  original  cost.  This  increase  in  value  is  to 
be  taken  as  a  profit,  but  since  the  profit  was  not  earned  dur- 
ing a  single  year,  but  represented  the  appreciation  in  value 
over  thirty  years,  it  will  be  improper  to  count  this  in  the 
surplus  available  for  distribution  to  stockholders.  It  will  be 
treated  in  the  same  manner  as  profits  arising  from  premiums 
on  the  sale  of  securities.  In  cases,  however,  where  the  com- 
pany purchases  and  sells  property  in  the  same  year  and  shows 
a  profit  on  the  transaction,  this  profit  may  be  included  in 
the  annual  profits  of  the  company  upon  which  the  distribu- 
tion of  profits  is  to  be  based. 

Profits  arising  from  the  revaluation  of  assets  are  doubtful. 
It  is  frequently  necessary,  when  the  property  of  a  business 
has  been  subjected  to  some  unusual  damage  which  is  too 
great  to  be  covered  by  the  ordinary  rate  of  depreciation,  for 
example  the  discovery  of  new  and  richer  deposits  of  iron 
ore  which  will  reduce  the  valuation  to  be  legitimately  placed 
upon  a  company's  iron-ore  deposits,  to  write  down  the  book 
value  of  assets  in  the  form  of  a  loss  on  the  single  year's 
operation,  or,  if  the  depreciation  is  excessive,  to  spread  this 


206  COKPOKATION   FINANCE 

loss  over  a  series  of  years.  On  the  other  hand,  it  has  been 
urged  that  the  writing  up  of  assets  where  property  has  ap- 
preciated in  value  is  equally  legitimate.  This  can  be  admitted 
only  within  narrow  limits.  It  is  entirely  proper  in  the  case 
of  securities  owned  where  the  market  value  can  be  ascertained, 
and  where  the  increased  income  corresponds  to  the  increased 
price.  Beyond  this,  however,  the  "  writing  up  "  of  assets  is 
of  doubtful  propriety.  It  is  safer  to  maintain  a  book  value 
of  securities  based  upon  cost,  less  depreciation,  and  to  leave 
the  surplus  account  undisturbed  by  any  appreciation  in  their 
market  value. 

The  danger  of  thus  appreciating  assets  may  be  seen  by 
an  illustration.  The  property  on  which  the  Broad  Street 
Terminal  of  the  Pennsylvania  Eailroad  Station  stands  has 
increased  over  400  per  cent  since  purchase.  If  this  piece  of 
real  estate  was  to  be  revalued,  its  original  cost  to  the  com- 
pany would  be  quadrupled.  Broad  Street  Station  is,  however, 
not  to  be  sold.  It  will  for  many  years  continue  to  be  used 
for  the  purpose  of  the  company.  It  is  altogether  probable 
that  the  contribution  of  this  terminal  location  to  the  profits 
of  the  Pennsylvania  Eailroad  has  not  increased  as  rapidly  as 
its  value  as  real  estate.  At  the  same  time,  it  is  impossible  to 
ascertain  how  much  is  this  increase  in  the  contribution  of 
Broad  Street  Station  to  the  net  profits  of  the  Pennsylvania. 
The  only  basis  on  which  its  value  could  be  written  up 
upon  the  books  of  the  company  would  be  by  comparing  it 
with  the  value  of  real  estate  in  the  vicinity.  This  would 
result  in  an  exaggeration  of  its  value  as  a  piece  of  property 
producing  revenue  for  the  Pennsylvania  Eailroad.  The  New 
Yo!  k.  New  Haven  &  Hartford  has  a  three  fourths  inter- 
est in  the  South  Station,  Boston,  which  cost  $15,000,000 
to  build.  The  loss  on  the  operation  of  this  station,  how- 
ever, which  is  maintained  largely  for  public  convenience 
has  been  as  high  as  $500,000  in  a  single  year.  As  a  piece 
of  real  estate  this  property  is  very  valuable.  As  a  piece  of 
railroad  property,  however,  it  is  a  source  of  loss. 

The  only  practical  reason  for  increasing  the  value  of  rail- 


THE   DETEKMINATION   OF   PKOFITS  207 

road  terminal  property  would  be  when  it  is  desired  to  make 
this  the  basis  for  an  issue  of  terminal  bonds.  In  such  a  case, 
however,  the  lenders  will  make  their  own  estimates  as  to  the 
value  of  the  real  estate  in  question  as  security  for  the  loan 
asked,  and  the  corporation  need  not  adopt  the  expedient  of 
writing  up  the  value  of  the  property  on  its  books.  All  things 
considered,  the  method  of  carrying  the  property  of  the  com- 
pany at  its  original  cost,  and  maintaining  that  cost  intact 
by  proper  rates  of  depreciation  is  best. 


CHAPTER   XVI 

THE   MANAGEMENT   OF  THE   CORPORATE  INCOME 

^Corporations  exist  and  do  business  to  produce  dividends 
for  their  owners.'  A  company  which  has  no  prospect  of 
paying  dividends  should  be  either  dissolved,  or,  according 
to  methods  which  we  shall  have  later  occasion  to  explain, 
reorganized  down  to  a  dividend  basis.  After  making  the 
various  deductions  which  have  been  indicated,  the  surplus 
profits  belong  to  the  stockholders,  and  if  the  company  is  suc- 
cessfully managed  under  conditions  of  ordinary  good  fortune, 
the  stockholders  will  in  time  receive  these  surplus  profits, 
directly  or  indirectly,  either  in  the  form  of  cash  or  dividends. 
I  A  dividend  is  a  payment  of  the  profits  of  the  company  to 
its  stockholders  expressed  in  the  form  of  a  certain  rate  per 
cent  on  the  par  value  of  the  stock.)  The  dividend  of  the 
Pennsylvania  Railroad  Company  is  $3 — six  per  cent  on 
8,021,296  shares,  amount  of  capital  stock  $401,064,800 ;  that 
of  the  United  States  Steel  Corporation  seven  per  cent  on 
3,602,811  shares  of  preferred  stock,  and  $5  on  5,083,025 
shares  of  common  stock.  The  General  Electric  Company 
pay-  $8  per  share  on  651,674  shares;  the  Union  Pacific 
Railroad  Company  pays  $10  on  2,961,787  shares  of  com- 
mon stock. 

There  are  two  steps  in  the  process  of  distributing  profits 
to  stockholders':  First,  the  directors  by  a  formal  resolution 
declare  that  profits  have  been  earned.  As  a  preliminary 
to  the  declaration  of  a  dividend,'  the  directors  consider  the 
following:,  (1)  the  cash  or  liquid  assets  of  the  company 
208 


MANAGEMENT   OF   CORPORATE   INCOME     209 

at  that  time  from  which  the  dividends  must  be  taken;  (2) 
(the  prospect  of  business  for  the  early  future;  (3)  the  abil- 
ity of  the  company  to  obtain  any  funds  which  may  be  neces- 
sary for  new  construction  by  the  sale  of  new  stock  or  bonds. 
A  company  may  be  exceptionally  prosperous  without  being 
able,  on  account  of  the  rapid  growth  in  its  business  which  has 
locked  up  its  cash  assets  in  the  form  of  accounts  receivable, 
materials,  etc.,  to  pay  out  any  portion  of  these  profits  in 
dividends.  A  declaration  of  a  dividend,  under  these  circum- 
stances, could  be  made  only  by  selling  stock  or  notes  to 
obtain  the  money,  and  while  this  is  sometimes  done,  as  a 
common  practice  it  is  to  be  avoided.  Again,  the  business 
of  the  company,  at  the  time  when  the  matter  of  paying  a 
dividend  is  considered,  may  be  exceptionally  prosperous,  but 
the  outlook  for  the  future  may  be  in  doubt.  At  a  time,  for 
example,  when  a  revision  of  the  tariff  is  in  progress,  the 
companies  whose  earnings  will  be  affected  by  any  changes 
under  consideration  are  inclined  to  husband  their  resources 
and  prepare  for  a  possible  shrinkage  in  earnings.  A  com- 
pany whose  business  is  rapidly  expanding  may  require  large 
amounts  of  new  capital.  It  may  not  be  desirable  to  raise 
this  money  by  increasing  capital  stock.  Any  money  required 
must  come  out  of  profits.  The  directors,  under  such  condi- 
tions, would  be  cautious  in  paying  dividends. 

(The  law  provides  that  the  declaration  of  dividends  is 
optional  with  the  directors.:  They  have  authority  to  fix  the 
amount  of  working  capital  which,  in  their  judgment,  the 
business  of  the  corporation  requires,  and  until  they  declare 
a  dividend  by  resolution,  there  is  no  way  in  which  the  stock- 
holder, except  by  his  vote  to  displace  one  or  more  directors, 
can  control  their  action.  The  directors  are  the  trustees  for 
the  stockholders.  They  are  given  full  power  to  dispose  of 
the  funds  of  the  corporation  as  their  best  judgment  may 
direct.  No  matter  how  large  are  the  profits  of  the  company, 
there  is  no  way  in  which  they  can  be  compelled  to  declare 
a  dividend.  The  stockholders  can  only  participate  in  profits 
through  the  channel  provided  by  law.    Various  attempts  have 


210  COKPOKATION   FINAKCE 

been  made  to  force  a  declaration  of  dividends,  especially  on 
preferred  stock,  on  the  ground  that  large  profits  had  been 
earned,  and  that  the  stockholders  were  entitled  to  share  in 
these  profits.  These  attempts  have  been  generally  unsuc- 
cessful. The  stockholder  can  invoke  the  aid  of  the  courts 
to  prevent  the  diversion  of  the  company's  funds  to  unlawful 
objects;  he  can  restrain  the  officers  and  directors  from  paying 
to  themselves  exorbitant  salaries;  and  he  can  prevent  any 
improper  use  of  the  company's  profits.  As  long,  however, 
as  the  directors  elect  to  leave  the  company's  profits  in  the 
treasury,  until  they  decide  that  a  dividend  shall  be  paid,  the 
stockholder  can  obtain  no  share  of  these  profits.  His  only 
remedy,  in  case  he  is  dissatisfied  with  the  management  of 
the  company,  is  to  elect  new  directors  or  sell  his  stock  and 
withdraw  from  the  company.  When  a  dividend  has  been 
declared,  however,  it  becomes  an  obligation  of  the  company, 
enforcable  as  any  other  debt. 

'The  object  which  an  honest  and  conservative  board  of/ 
directors  set  before  them  is  to  establish  a  dividend  rate 
which  can  be  maintained  under  all  conditions  of  earningsb 
The  interests  of  the  stockholder  and  the  corporation  unite 
in  the  demand  that  a  rate  of  dividend  once  established  shall 
be  maintained.  The  stockholder  desires  a  stable  dividend 
because  the  value  of  a  stock  whose  dividends,  for  example, 
run  six,  six,  two,  two,  and  four,  averaging  four  per  cent  for 
the  five  years,  but  irregularly  distributed,  will  command  a 
lower  price  than  stock  on  which  four  per  cent  is  paid  every 
year.  Investors,  as  distinct  from  speculators,  although  both 
elements  are  present  in  the  minds  of  both  purchasers  of  stock, 
desire  stability  in  the  income  from  their  investments.  The 
dividends  which  they  receive  go  into  their  personal  income 
accounts;  their  expenditures  and  appropriations  are  adjusted 
to  these  receipts;  a  reduction  or  the  passing  of  a  dividend 
disturbs  their  calculations  and  unsettles  their  confidence  in 
the  company.  As  a  result  of  this  preference  of  the  investor 
for  stocks  with  a  regular  rate  of  distribution,  the  payment 
of  regular  dividends  produces  a  higher  and  more  stable  value 


MANAGEMENT   OF   CORPORATE   INCOME     211 


for  sucli  stocks.     Stocks  with  regular  dividends  are  worth 
more  to  sell  and  are  also  more  valuable  as  collateral  security. 
A  stable  rate  of  dividend  with  its  resulting  higher  and 
more  permanent  value  is  of  great  advantage  to  the  company. 
Many  corporations,  especially  those  whose  receipts  are  not 
evenly    distributed   throughout   the   year,    have   occasion   to 
borrow  money  in  anticipation  of  income  to  meet  obligations 
which  mature  before  that  income  is  received.    Wages,  inter- 
est, and  taxes  must  be  paid  and  supplies  purchased  often 
before  the  proceeds  of  sales  are  received.     In  order  that  a 
corporation  should  retain  a  strong  position  with  the  banks, 
it  is  important  that  its  stock  should  be  maintained  at  a  good 
figure.    A  high  and  sustained  value  for  the  stock  of  a  com^ 
pany  is  ordinarily  taken  by  the  bank  as  evidence  of  its  high( 
credit.    Of  course,  if  this  value  is  merely  a  recent  marking  up 
of  stock-exchange  quotations,  it  may  not  have  much  weight 
with   the  bank  ofificers,  but  if  it  is  a  steadily  maintained 
quotation,   and   represents  what   investors   really   regard   as 
the  value  of  the  stock,  the  banker  considers  it  good  evidence 
of  the   financial   standing  of  the   company  applying  for  a 
loan.     On  the  other  hand,  the  fact  that  a  stock  sells  at  al 
low  price  is  usually  a  warning  to  the  banker  to  discriminate! 
against  the  paper  of  the  corporation  issuing  the  stock,  unless 
the  notes  are  well  secured  by  indorsement  or  collateral.       ^ 
A  settled  investment  value  for  its  securities,  which  can 
be  obtained  only  by  the  stability  of  its  dividend  rate,  also 
benefits  the  corporation  because  it  makes  it  possible  for  it  to 
procure  money  for  improvements  and  extensions  on  favorable 
terms.    A  prosperous  company  is  a  growing  company,  and  is 
under  frequent  necessity  of  selling  stock  or  bonds  to  obtain 
new  capital.    The  prices  obtained  for  the  new  securities  will 
depend  to  a  large  extent  upon  the  prices  of  those  already  out- 
standing.    If  the  company  issues  bonds,  a  high  value  for 
the  stock  indicates  that  the  interest  on  these  bonds  is  amply 
secured  by  surplus  earnings.    If,  however,  the  stock  is  selling 
at  a  low  figure,  the  investor  knows  that  the  company  which 
proposes  to  increase  its  debt  has  little  security  to  offer  its 


212  COEPORATION   FINANCE 

creditors  aside  from  the  property  which  the  proceeds  of  the 
new  bonds  are  to  purchase.  A  low  price  of  the  stock  in- 
dicates that  the  judgment  of  market  observers  is  unfavor- 
able to  the  company.  The  investor  properly  regards  the  past 
achievements  of  the  corporation  as  the  best  assurances  of  its 
future,  prosperity.  No  matter  how  large  the  net  earnings  of 
a  company  may  be  at  the  time  an  increase  of  stock  or  bonds 
is  made,  the  low  market  value  of  this  stock  resulting  from 
an  irregular  dividend  policy  would  be  a  warning  to  anyone 
investigating  its  credit  that  there  was  good  reason  for  be- 
lieving that  these  large  earnings  would  not  be  permanent. 
Under  these  circumstances,  it  might  be  difficult  to  obtain 
high  prices  for  these  securities. 

So  important  is  an  even  distribution  of  corporate  profits 
considered,  that  even  when  increasing  earnings  enable  the 
corporation  to  raise  the  rate  of  dividend,  care  is  usually 
taken  to  avoid  any  official  statement,  or  even  any  implication 
from  a  statement,  that  the  higher  dividend  rate  is  to  be  per- 
manent. The  method  employed  in  such  cases  is  to  declare 
the  "  regular  "  dividend  and  then  an  "  extra "  dividend  in 
addition.  The  increase  is  made  in  the  form  of  the  "  extra  " 
dividend  as  an  intimation  to  the  stockholder  that  the  di- 
rectors are  not  yet  fully  convinced  that  they  can  add  the 
amount  of  the  "  extra "  to  the  regular  rate,  and  that  they 
prefer  to  wait  developments  before  establishing  the  regular 
rate  at  the  higher  figures.  After  the  extra  dividend  has 
been  paid  for  several  years,  and  if  profits  are  maintained, 
the  rate  will  be  made  regular.  In  order  to  maintain  an  even 
rate  of  distribution  on  its  stock,  the  directors  of  well-man- 
aged companies  are  governed  by  the  following  rules: 

First,  to  pay  no  dividends  for  a  considerable  period  after 
the  company  begins  operation. 

Second,  to  manage  the  expense  accounts  of  the  company 
/  in  such  a  way  as  to  reduce  the  fluctuations  in  surplus  profits 
to  the  minimum. 

Third,  to  pay  out,  in  any  one  year,  only  a  portion  of 
these  profits  in  dividends. 


MANAGEMENT   OF   CORPOKATE   INCOME    213 

Every  new  corporation  is,  in  some  degree,  an  experiment. 
Even  though  it  operates  in  an  industry  where  the  machinery, 
the  methods  of  administration,  and  the  product  are  standard- 
ized, and  where  the  management  have  nothing  more  to  do 
than  to  follow  established  models,  the  degree  of  its  success 
cannot  be  accurately  predicted.  The  number  of  unknown 
factors  in  every  business  situation  is  large;  new  laws  to 
reduce  profits,  increases  in  taxation,  unusual  burdens  im- 
posed by  the  municipality  in  the  way  of  public  improvements, 
the  incursions  of  competitors,  changes  in  the  tariff,  dangers 
of  industrial  depression,  encroachments  of  organized  labor, 
substitutions  of  new  products  or  the  invention  of  machinery 
to  produce  at  lower  cost — these  influences  may  enter  to  dis- 
appoint the  calculations  of  the  directors.  Furthermore,  in 
most  public  flotations,  there  is  some  overvaluation  of  the 
property  purchased  or  constructed,  and  a  corresponding 
element  of  inflation  in  the  capitalization  of  the  company. 
Even  with  the  most  painstaking  care,  mistakes  of  construc- 
tion, location,  or  anticipation  of  demand  may  have  been  made. 
If  the  company  is  prosperous,  these  mistakes  can  be  rectified, 
but  the  money  with  which  these  replacement  and  insurance 
funds  are  built  up  comes  from  the  profits  of  the  company. 
Conservative  directors  will,  therefore,  usually  refuse  to  pay^, 
out  profits  until  the  company  has  demonstrated  its  ability 
to  earn  its  fixed  charges,  and  to  produce  a  surplus  out  of  , 
which  dividends  can  be  paid. 

The  issue  of  cumulative  preferred  stock  seriously  inter-"A 
feres  with  a  conservative  management  of  the  company's  in-J 
come.  When  dividends  are  carried  over  and  accumulated 
to  the  prejudice  of  the  common  stockholder,  fairness  to  him, 
as  well  as  the  usual  necessity  that  a  market  should  be  made 
for  new  securities  as  quickly  as  possible,  influences  the  di- 
rectors to  promptly  begin  the  payment  of  dividends  upon  the 
preferred  stock.  In  some  cases,  notably  that  of  the  United 
States  Steel  Corporation,  the  stock-market  situation  influ- 
enced the  directors  to  immediately  begin  payment  of  divi- 
dends on  the  common  stock  as  well  as  on  the  preferred.  For 
15 


214  CORPOKATION   FINANCE 

this,  however,  they  were  severely  criticised.  The  position  of 
the  company  during  the  early  period  of  its  existence  was 
weakened  by  a  policy  of  dividend  payment  which  was  gen- 
erally believed  to  be  unduly  liberal.  In  December,  1903, 
the  depressed  condition  of  the  steel  trade  led  to  the  suspension 
of  dividends  on  the  common  stock  of  the  United  States 
Steel  Corporation.  The  directors  quickly  took  advantage  of 
the  opportunity  to  adopt  a  conservative  dividend  policy. 
Although  the  depression  in  the  steel  trade  was  only  tem- 
porary, conditions  approaching  normal  in  the  following  year, 
the  policy  of  investing  large  sums  in  plant  and  equipment 
which  the  directors  would  probably  have  been  glad  to  follow 
from  the  first,  had  stock-market  considerations  not  proved 
controlling,  was  steadily  adherred  to.  No  dividends  were 
paid  on  steel  common  until  1906,  when  a  two-per-cent  rate 
was  established,  raised  a  year  later  first  to  three  and  then 
to  four  per  cent.  Not  until  the  autumn  of  1909,  was  the  rate 
advanced  to  five  per  cent.  During  this  period  from  1903 
to  1909,  the  company  earned  $300,044,000  on  its  common 
stock  and  paid  only  $63,537,813  in  dividends,  the  balance 
being  invested  in  various  reserves,  and  in  building  up  a  sur- 
plus on  the  balance  sheet  which,  at  the  date  of  the  last  annual 
report,  stood  at  $151,354,528.  As  a  result  of  this  policy  of 
investing  profits  in  improvements,  instead  of  paying  them  out 
in  dividends,  the  United  States  Steel  Corporation  has  elimi- 
nated much  of  the  "  water  "  .  in  its  original  capitalization, 
and  has  placed  itself  in  a  strong  position  to  continue  the 
payment  of  the  five-per-cent  dividend — recently  announced 
by  the  directors  as  the  regular  dividend  on  the  common 
stock. 

The  later  policy  of  the  United  States  Steel  Corporation 
in  sacrificing  its  dividends  to  its  surplus  indicates  the  policy 
which  every  company  whose  financial  situation  permits  should 
follow.  In  no  other  way  can  a  corporation  whose  capital  i^ 
excessive,  and  whose  earning  power  is  in  any  way  doubtful, 
so  certainly  reach  an  investment  position  as  by  adherence  to 
the  policy  of  accumulating  a  large  reserve  out  of  income. 


MANAGEMENT   OF   COEPOKATE   INCOME     215 

The  more  doubtful  the  success  of  the  company,  and  the 
greater  the  number  of  dangers  and  risks  to  which  it  is 
subjected,  the  more  important  it  is  that  dividends  should 
be  withheld  until  a  strong  financial  position  is  attained. 

Having  fulfilled  the  initial  requirement  of  accumulating 
an  adequate  reserve  to  offset  the  blunders  of  omission  and 
commission  which  characterize  the  beginning  of  every  new 
enterprise,  the  next  problem  confronting  the  ^directors  of  a 
company,  anxious  to  place  their  stock  upon  a  dividend  payingr 
basis,!  is  the  management  of  the  expense  accounts  in  such  aj 
manner  as  to  reduce  to  a  minimum  the  fluctuations  in  the! 
income  available  for  distribution  to  stockholders.^  A  large 
part  of  the  expense  of  operating  any  business  varies  with  the 
volume  of  business  done.  An  increase  in  the  traffic  of  a 
railroad  means  more  trains,  and  more  employees  to  run  the 
trains  and  to  keep  them  in  repair.  A  falling  off  in  business 
results  in  a  corresponding  reduction  in  the  cost  of  conducting 
transportation.  The  same  is  true  of  all  other  industries. 
The  cost  of  operating  the  plant,  as  distinct  from  the  costi 
of  maintaining  it,  fluctuates  with  the  amount  of  business 
done.  There  are,  of  course,  in  every  business  certain  fixed 
expenses  connected  with  the  operation  and  selling  which  can- 
not be  adjusted  to  changes  in  business,  and  which  result  in 
increased  cost  when  earnings  are  reduced.  Broadly  speak- 
ing, however,  the  cost  of  running  the  plant,  of  manufactur- 
ing the  goods,  or  transporting  the  freight  and  passengers, 
changes  with  the  volume  of  business  transacted.  There  is 
little  opportunity,  therefore,  in  the  cost  of  operation,  to  ad- 
just expenditure  to  fluctuations  of  income  so  as  to  minimize 
the  changes  in  the  balance  of  income  available  for  distribu- 
tion to  stockholders. 

In  the  maintenance  and  replacement  items  of  operating 
expenses,  however,  a  certain  amount  of  adjustment  and  varia- 
tion is  possible.  Maintenance  charges,  as  we  have  seen,  con- 
tain two  items :  the  cost  of  up-keep  and  repairs,  and  the  cost 
of  betterments  calculated  to  raise  the  standard  of  construction 
and  decrease  the  cost  of  maintenance  or  operation.     The 


216  CORPOKATION   FINANCE 

rule  which  governs  the  management  of  the  fir&t  class  of 
maintenance  expenses  is  that,  so  far  as  possible,  without  dam- 
aging the  credit  of  the  company,  standards  of  maintenance 
once  established  should  be  rigidly  adherred  to.  Maintenance, 
in  other  words,  should  be  a  comparatively  fixed  expense,  vary- 
ing only  as  the  influences  which  affect  the  wear  and  destruc- 
tion of  the  property  are  modified. 

Rigid  adherence  to  this  rule  admits  of  a  considerable 
amount  of  fluctuation  in  the  amount  of  annual  appropriations 
for  the  up-keep  of  the  property.  The  cost  of  railway  main- 
tenance of  way,  for  example,  is  increased  by  an  open  winter, 
which  results  in  greater  damage  to  the  track  and  roadway. 
It  is  increased  by  the  high  cost  of  labor  and  material  incident 
to  business  prosperity,  and  also  by  the  heavy  traffic  which 
results  from  large  production.  Maintenance  cost,  on  the 
other  hand,  is  naturally  reduced,  without  injury  to  the  prop- 
erty, during  periods  of  depression.  When  traffic  is  light,  the 
wear  upon  the  track  is  reduced,  the  amount  paid  out  in 
wages  is  lessened.  The  efficiency  of  labor  is  also  increased 
at  such  a  time,  not  merely  because  of  the  greater  desirability 
of  steady  employment  during  a  dull  season,  which  can  only 
be  secured  at  such  a  time  by  diligence  and  faithful  service, 
but  also  because  track  work  is  not  so  much  interfered  with 
by  passing  trains.  The  cost  of  materials  is  also  reduced 
during  periods  of  depression.  The  maintenance  of  plant  or 
equipment  not  directly  affected  by  weather  conditions  can 
also  be  reduced  during  the  period  of  depression  without 
injury  to  the  property.  The  Pennsylvania  railroad,  for  ex- 
ample, made  a  heavy  reduction  in  the  cost  of  maintaining 
equipment  during  1908,  amounting  to  $6,864,247.  This  was 
due  to  the  fact  that  a  large  portion  of  its  equipment  was  not 
in  service,  and  consequently  was  not  subjected  to  the  wear 
and  tear  of  operation.  A  large  amount  of  substitution  of 
parts,  such  as  air-brake  hose,  belting,  etc.,  can  be  made  dur- 
ing a  dull  season,  when  only  a  portion  of  the  plant  or  equip- 
ment is  in  operation,  thus  reducing  the  cost  of  maintenance. 
A  ease  in  point  is  a  factory  manufacturing  leather  goods 


MANAGEMENT   OF   COKPOKATE   INCOME     217 

which  had  four  floors  in  operation  during  1907.  In  1908 
business  fell  off  so  that  only  the  machinery  on  the  one  floor 
was  used.  As  fast  as  the  belting  wore  out  on  the  lower 
floor,  belts  were  transferred  from  idle  machines,  where  they 
would  naturally  deteriorate,  and  put  into  use.  Such  econ- 
omies of  maintenance  do  not  involve  any  lowering  of  the 
standard  of  the  plant,  although  the  cost  of  maintenance  may 
be  greatly  increased  to  restore  the  equipment  used  up  in  this 
manner  when  the  entire  plant  again  comes  into  operation. 
/  With  this  exception,  however,  the  safe  rule  to  follow  in 
maintaining  the  standard  once  established  for  a  plant  is 
that  a  '^stitch  in  time  saves  nine?]  Neglect  of  maintenance, 
for  any  reason,  is  likely  to  be  followed  by  the  most  serious 
consequences.  The  operating  efficiency  of  a  plant  is  so  closely 
related  to  its  physical  condition,  the  success  of  its  business 
is  so  dependent  upon  its  efficiency  of  operation,  that  serious 
and  permanent  damage  may  be  inflicted  upon  a  company  by 
failure  to  maintain  the  standards  of  its  plant.  A  good  illus- 
tration of  the  conseqilences  of  neglecting  maintenance  is  fur- 
nished by  the  fifth  annual  report  of  the  Kansas  City  South- 
ern Eailway  Company  for  the  fiscal  year  ending  June  30, 
1905.  The  capital  stock  of  this  company  was  originally  vested 
in  a  voting  trust  for  five  years  from  April  1,  1900.  This 
voting  trust  expired  by  limitation  on  April  1,  1905,  when 
the  stockholders  came  into  possession  of  their  property  and 
elected  a  new  board  of  directors. 

They  found  the  road  in  such  a  condition  as  to  be  prac- 
tically unfit  to  carry  on  the  business  of  transportation ;  twenty- 
five  per  cent  of  the  engines  were  in  bad  order,  sixty-five  per 
cent  of  the  freight  equipment  was  unfit  for  use  in  the  trans- 
portation of  grain,  merchandise  and  other  freight  demanding 
dry  cars;  fifty-five  of  the  sixty- five  per  cent  required  heavy 
repairs,  enough  ties  had  not  been  renewed,  ditches  had  not 
been  cleaned,  sufficient  ballasting  had  not  been  done  and  suf- 
ficient rail  had*  not  been  laid.  The  condition  of  the  ties 
and  wooden  structures  and  track,  as  a  result  of  the  neglect 
of  maintenance,  was  so  bad  that  it  was  impossible  to  move 


218  COEPOKATION   FINANCE 

trains  at  ordinary  speed.  During  the  six  months  from  Jan- 
uary 7th  to  June  30,  1905,  as  a  result  of  the  impaired  con- 
dition of  the  property  due  to  the  neglect  of  its  maintenance, 
there  were  715  wrecks  and  derailments  reported,  "  each  of 
which  was  of  sufficient  magnitude  to  require  a  special  report 
and  therefore  cause  serious  loss  and  delay.  Such  a  great 
number  of  accidents  could  not  fail  to  cause  serious  loss  of 
confidence  and  good  will  of  the  public  and  consequent  diver- 
sion of  traffic,  also  destruction  and  damage  to  property,  delay 
to  trains,  and  resulting  wasteful  expense  for  extra  fuel  and 
overtime  of  employees."  ^  During  the  month  of  May,  1905, 
overtime  paid  engine  and  train  crews  amounted  to  $8,311.38, 
although  the  average  of  overtime  for  the  three  years  preced- 
ing, before  the  property  had  reached  its  worst  condition, 
was  $5,990.88.  In  addition  large  amounts  were  paid  each 
month  for  labor  in  rerailing  cars  and  engines,  and  for  re- 
pairing track  and  equipment,  as  a  result  of  derailment  due 
to  defective  tracks.  Large  amounts  were  paid  for  loss  and 
damage  to  freight  due  to  such  derailments.  Finally,  the 
company  suffered  severely  in  competition  for  business  be- 
cause of  its  inability  to  take  all  the  traffic  which  might  have 
been  obtained,  and  also  because  the  traffic  which  it  did  move 
was  often  seriously  delayed  in  delivery  and  arrived  in  bad 
condition. 

We  see  illustrated,  in  the  case  of  the  Kansas  City  South- 
ern, the  effect  of  the  neglect  of  maintenance  upon  opera- 
ting efficiency,  and  the  effect  of  decreased  operating  effi- 
ciency upon  traffic  and  earnings.  While  this  is  an  extreme 
case,  it  illustrates  a  principle  which  is  of  invariable  applica- 
tion. To  allow  a  property  to  run  down  is  to  impair  the 
property's  efficiency  and  to  inflict  serious  injury  upon  the 
operating  company. 

It  is  possible,  however,  and  this  is  the  practice  of  many 
corporations,  especially  those  which  have  not  yet  reached  a 
position  where  they  can  show  large  surpluses  over  the  amount 

*  Fifth   annual    report   of   The    Kansas   City   Southern    Railway 
Company,  fiscal  year  ended  June  30,  1905. 


MANAGEMENT   OF   CORPOKATE   INCOME     219 

required  for  their  dividends,  to  vary  their  appropriations  for 
maintenance  according  to  their  earnings,  never  allowing  the 
condition  of  the  property  to  deteriorate  so  far  as  to  interfere 
with  its  efficiency,  but  postponing,  on  occasion,  all  but  the 
most  necessary  replacements  and  repairs  until  earnings  have 
improved.  Such  a  policy  may  be  justified  by  extreme  finan- 
cial necessity.  When  a  reduction  in  the  dividend  of  a  com- 
pany will  impair  the  company's  credit,  or  defeat  the  con- 
summation of  projects  for  raising  large  amounts  of  capital, 
the  skimping  of  maintenance  cost  may  be  pardoned.  A  board 
of  directors  are  always  reluctant  to  reduce  the  dividend  rate. 
Such  action  inflicts  serious  damage  upon  the  stockholders, 
and  is  likely  to  lead  to  unforeseen  criticisms.  When  com- 
panies are  running  on  a  narrow  margin  of  earnings,  their 
usual  disposition,  when  conditions  of  reduced  earnings  are 
encountered,  is  to  save  at  the  expense  of  the  plant.  It  is 
going  too  far  to  say  that  such  a  policy  is  never  justifiable. 
Each  case  must  be  determined  on  its  own  merits,  with  refer- 
ence to  the  peculiar  circumstances  in  which  the  directors  of 
the  company  find  themselves.  It  is,  however,  well  established 
that  the  policy  of  so-called  "  concentration  "  of  maintenance 
expenses  into  years  of  large  earnings  is  costly,  in  that  it 
results  in  a  higher  average  of  expenses  over  a  series  of  years 
in  keeping  the  plant  in  condition,  than  would  be  necessary 
if  fixed  repairs  were  made. 

This  subject  was  investigated  in  1908  by  a  committee  of 
the  American  Street  Railway  Association.  In  their  report 
they  present  the  detailed  figures  of  maintaining  car  bodies 
over  ten  years,  first,  when  the  car  is  put  in  the  shop  each 
year,  and  second,  when  it  is  shopped  bi-yearly.  The  com- 
parison of  the  cost  of  maintaining  car  bodies  under  the 
yearly  and  bi-yearly  systems  of  shopping  is  shown  in  the 
table  on  the  following  page. 

To  the  cost  of  the  yearly  maintenance  over  the  ten  years, 
should  be  added  an  estimated  item  of  $44,40  on  account  of 
the  additional  equipment  made  necessary  because  of  four 
days  loss  of  time  on  each  car  while  in  the  shop,  and  an  item 


220 


COKPOKATION   riNANCE 

Cost 


Shopped  Yearly 

Shopped 
Bi-Yearly 

1st  year                        

$29.18 
61.49 
54.94 
60.99 
60.44 
59.99 
54.94 
67.74 
55.44 
79.99 

2d     "    

$86.46 

3d     " 

4th    " 

97.46 

5th    "                                    

6th    "                     

111.46 

7th    "                         

8th    " 

115.96 

9th    "            

10th    "                                

143.15 

Total. .  . 

$585.14 

$554.45 

of  $10.40  on  account  of  increased  shoproom  made  necessary 
by  the  yearly  maintenance,  making  a  total  of  $639.85  as  the 
cost  of  maintaining  the  cars  when  shopped  yearly  as  com- 
pared with  $554.45,  the  cost  of  bi-yearly  repairs.  This  com- 
parison, however,  does  not  indicate  the  merits  of  the  respec- 
tive policies.  The  objects  of  car  maintenance  as  stated  by 
the  committee  are  as  follows: 

First,  to  prevent  accidents  due  to  defective  equipment. 

Second,  to  prevent  failure  of  service  due  to  defective 
equipment. 

Third,  to  prevent  excessive  depreciation  of  equipment. 

Fourth,  to  maintain  equipment  comfortable  and  attractive 
to  patrons  and  public. 

The  committee  finds  a  marked  saving  under  each  one  of 
these  items  as  result  of  shopping  the  cars  every  year.  First, 
less  liability  to  accidents.  "When  a  car  is  thoroughly  over- 
hauled each  year,  there  is  less  liability  of  accidents  due  to 
defective  flooring,  straps,  windows,  door  and  seat  mechan- 
ism than  where  such  overhauling  is  done  every  second  year. 
If  such  accident  claims  are  made,  the  fact  that  the  car  had 
been  carefully  overhauled  inside  of  a  year  would  greatly 
improve  the  railway  company's  case  in  court,  and  it  would 
seem  that  two  cents  per  car  per  day  would  be  a  conservative 


MANAGEMENT   OF   COKPOKATE .  INCOME     221 

estimate  of  its  value."  The  liability  to  failure  in  service  was 
also  decreased  by  frequent  overhauling.  The  life  of  the  car 
body  is  also  increased  when  the  cars  are  put  into  the  shop 
every  year.  "  Very  few  electric  car  bodies  have  been  aban- 
doned on  account  of  deterioration.  Many  have  been  retired 
on  account  of  being  obsolete  and  unprofitable  to  operate. 
Therefore,  the  proper  value  for  ordinary  depreciation  is  hard 
to  determine,  but  it  is  a  well-known  fact  that  where  wood  is 
exposed  to  moisture  it  will  deteriorate  rapidly,  that  paint 
and  varnish  will  crack  at  joints  if  they  are  not  kept  well 
covered  and  the  varnish  elastic,  and  that  floors  and  sills  will 
rot  if  they  are  not  kept  well  painted.  Therefore,  it  is  safe 
to  estimate  that  the  life  of  a  car  body  which  has  received 
proper  attention  each  year  will  be  ten  per  cent  greater  than 
one  receiving  attention  every  second  year. 

This  conclusion  of  the  committee  is  abundantly  borne 
out  by  examination  of  the  detailed  figures  of  maintenance 
of  cars  under  the  two  systems,  which  are  given  in  the  report. 
For  example,  the  item  of  general  woodwork  repairs  and 
tightening  up  fram.es,  under  the  system  of  yearly  shopping, 
cost  the  company  in  the  eighth  year  $15  and  in  the  tenth 
year  $15.50.  When  the  car  has  been  shopped  bi-yearly,  how- 
ever, this  item  cost  $45  for  the  eighth  year  and  $60  for  the 
tenth  year.  The  cost  of  varnishing  and  cleaning  and  reno- 
vating upholstery  and  curtains  is  also  much  greater  for  the 
later  years  of  the  period  than  on  cars  which  have  been 
shopped  yearly.  The  committee  estimates  that  the  life  of 
a  car  body  which  has  received  attention  every  year  is  ten 
per  cent  greater  than  one  receiving  attention  every  second 
year. 

There  is  also  a  great  advantage  in  yearly  maintenance  of 
equipment  in  reduced  cost  of  car  cleaning  and  in  greater 
attractiveness  leading  to  an  increase  in  revenue.  "It  will 
also  be  conceded,"  says  the  committee,  "  that  a  car  which  is 
kept  well  varnished  can  be  kept  clean  with  less  labor  than 
is  the  case  where  the  luster  is  gone  and  the  paint  exposed. 
This  would  amount  to  at  least  ten  per  cent  of  the  cost  of 


222 


COKPORATION  FINANCE 


keeping  the  woodwork  clean,  but  as  it  would  not  affect  the 
sweeping,  dusting  and  cleaning  of  glass,  five  per  cent  of  the 
total  car  cleaning  is  taken  as  a  fair  value. 

"  A  clean  car  excites  pride  in  the  car  crews,  tends  to  make 
them  more  attentive  to  their  personal  appearance,  their 
work  more  pleasant,  and,  in  consequence,  they  will  render 
better  service  to  the  company.  An  attractive  and  comfortable 
car  goes  a  long  way  toward  making  a  satisfied  passenger  and 
a  well-disposed  public." 

The  committee  estimates  the  gain  under  this  head  result- 
ing from  yearly  maintenance  at  ten  cents  per  car  per  day. 
The  final  comparison  of  the  results  of  yearly  and  bi-yearly 
maintenance  is  presented  in  the  following  table  of  costs  and 
credits : 

Summary  op  Costs  and  Credits 


Car  body  maintenance  (for  10 
years) 

Interest,  depreciation,  taxes  and 
insurance  (for  10  years)  on  addi- 
tional equipment  on  account  of 
being  in  shops  four  days  per 
year  more  than  when  shopped 
bi-yearly 

Interest,  etc.,  on  increased  shop 
room. 

Reduced  liability  of  accidents  for 
five  years  at  two  cents  per  day. 

Five  per  cent  saving  in  cost  of  car 
cleaning  for  five  years 

Value  of  car  being  more  attractive 
and  comfortable  to  passengers 
(at  ten  cents  per  day  for  five 
years) 

Decreased  depreciation  on  longer 
life  of  car  body  (ten  per  cent.) . 

Totals  for  ten  years 

Average  per  year 


Cars  Shopped  Yearly 


Costs 


$585.14 


44.40 
10.40 


$639.94 
63.99 


Credits 


$36.50 
84.65 

182.50 
61.50 


$365.15 
36.51 


Cars 

Shopped 
Bi-yearly 


$554.49 
55.44 


MANAGEMENT   OF   COKPOKATE   INCOME     223 

The  claim  of  regular  maintenance  could  not  be  more 
clearly  presented  than  in  the  final  results  of  this  comparison, 
showing  an  advantage  of  $27.96  for  the  method  of  yearly 
shopping.  From  every  standpoint  except  that  of  immediate 
saving,  the  policy  of  postponing  maintenance  is  to  be  con- 
demned, not  merely  because  of  its  effect  upon  the  property 
maintained,  but  also  because  of  the  impaired  operating  effi- 
ciency which  neglect  of  maintenance  always  brings  in  its 
train. 

Having  established  our  rules  for  the  financing  of  main- 
tenance, we  have  next  to  consider  the  financing  of  deprecia- 
tion. Shall  the  depreciation  charges  be  annually  deducted 
from  income  as  are  maintenance  charges  and  sinking  funds, 
or  shall  the  directors  be  given  a  certain  amount  of  liberty 
in  concentrating  these  charges  upon  years  of  large  earnings? 
The  various  public  service  commissions  which  have  passed 
rules  on  the  subject  and  the  Interstate  Commerce  Commission 
are  inclined  to  the  opinion  that  depreciation  should  be  a  fixed 
rule.    The  Wisconsin  commission,  for  example,  provides  that : 

Every  electric  railway  shall  carry  a  proper  and  ade- 
quate depreciation  reserve  to  cover  the  full  replace- 
ment of  all  tangible  capital  in  service.  There  shall 
be  opened  a  depreciation  account,  to  which  shall  be 
charged  monthly,  crediting  the  depreciation  reserve,  an 
amount  equal  to  one  twelfth  of  the  estimated  annual 
depreciation  of  the  tangible  capital  in  service  of  the 
railway,  or  as  near  that  amount  as  the  finances  of  the 
property  will  permit. 

On  the  other  hand,  the  practical  view  of  this  subject  is 
expressed  by  Mr.  Frank  R.  Ford,  of  Ford,  Bacon  &  Davis, 
electrical  railway  engineers,  in  a  paper  presented  at  the  mid- 
year meeting  of  the  American  Street  &  Interurban  Railway 
Association  on  January  28,  1910: 

The  depreciation  fund  is  essentially  a  financial  prob- 
lem, the  solution  of  which  is  apparently  by  law  left 
to  the  directors  of  the  corporation  as  they  are  em- 


224  CORPOKATION   FINANCE 

powered  to  determine  the  amount  of  current  income 
to  be  set  aside  for  working  capital  and  the  amount  of 
dividends  to  be  declared.  It  is  questionable  if  utilities 
commissions  can  lawfully  impose  rules  for  the  charg- 
ing of  depreciation  in  cases  where  the  physical  prop- 
erty is  fairly  maintained  and  securities  properly  is- 
sued. I  believe  that  no  hard  and  fast  rule  can  be  laid 
down  for  charging  a  fixed  amount  to  such  a  fund 
month  by  month  or  year  by  year;  the  proper  amount 
to  be  charged  should  be  known,  and  if  in  lean  years 
this  amount  is  not  laid  aside,  in  prosperous  years  the 
deficiency  should  be  made  up.  It  might  even  be  neces- 
sary to  use  this  fund  for  other  purposes  than  re- 
newal of  physical  property,  due  to  business  contin- 
gencies unforeseen. 

Mr.  Ford's  view  may  be  indorsed  since  it  conforms  to 
the  practice  of  corporations  noted  for  their  conservatism. 
Depreciation  differs  radically  from  maintenance,  interest,  and 
sinking  fund  charges  in  that  the  losses  to  provide  for  which 
depreciation  funds  are  built  up,  are  not  regularly  recurring. 
For  example,  a  power  plant  may  be  assumed  to  remain  in 
active  service  for  fifteen  to  twenty  years,  and  provision  should 
be  made  for  its  replacement  at  the  end  of  that  period.  It  is 
not  necessary,  therefore,  although  the  necessary  funds  must 
be  available  at  the  end  of  twenty  years,  that  one  twentieth  of 
the  amount  should  be  provided  in  each  year.  The  company 
can  take  advantage  of  years  of  large  earnings  to  increase  its 
appropriation  for  depreciation,  and  can  make  corresponding 
reductions  in  these  charges  when  earnings  are  small.  By 
adopting  this  policy,  the  company  can  maintain  an  average 
rate  sufficient  to  provide  for  the  depreciation  of  its  assets, 
while  it  can  distribute  the  annual  appropriations  so  that  they 
fall  lightly  in  years  of  small  earnings.  The  fluctuations  in 
the  surplus  available  for  dividends  are  thus  reduced  to  the 
minimum.  The  practice  of  the  United  States  Steel  Corpora- 
tion in  managing  its  depreciation  follows  the  rule  laid  down 
by  Mr.  Ford.  The  following  table"  gives  the  net  profits  of 
the  company,  the  amounts  set  aside  for  depreciation  and  ex- 


\\    . 

MANAGEMENT   OF   COKPOKATE   INCOME     225 

tinguishment,  the  payments  out  of  this  fund,  and  the  balance 
remaining,  for  the  first  seven  years  of  the  corporation's  his- 
tory : 

UNITED  STATES  STEEL  CORPORATION  AND  SUBSIDIARY 
COMPANY 

Depreciation  and  Extinguishment,  Extraordinary 
Replacement  and  Improvement 


1902 
1903 
1904 
1905 
1906 
1907 
1908 
1909 


Set  Aside 


$24,150,325.04 
23,897,353.36 
12,574,210.91 
21,665,063.04 
28,753,271.55 
28,025,124.41 
16,836,324.81 
24.447.673.00 


Payment 


$19,813,669.13 
24,937,033.95 
11,299,647.27 
16,109,701.72 
21,079,231.47 
26,995,540.51 
16,291,496.25 
14,739,939.79 


Balances 


$18,273,801.49 
17,568,222.39 
19,377,179.32 
26,792,216.37 
35,521,959.74 
38,038,842.56 
39,554,239.05 
50,630,279.45 


Net  Profits 


$90,306,525 
55,416,653 
30,267,539 
68,585,492 
98,128,587 

104,565,564 
45,728,714 
79,073,695 


An  examination  of  this  table  shows  that  when  the  com- 
pany's earnings  are  large,  its  appropriations  for  depreciation 
increase,  and  when  earnings  fall  off,  the  depreciation  allow- 
ances are  reduced.  The  two  years  of  smallest  earnings  for 
the  corporation  were  1904  and  1908.  In  1904  the  deprecia- 
tion appropriations  were  reduced  nearly  fifty  per  cent,  and 
in  1908  forty  per  cent.  If  the  company  had  appropriated 
in  1904  and  1908  the  average  amount  for  the  entire  peri- 
od, it  could  not  have  paid  its  full  rates  of  dividend  out  of 
the  surplus  of  these  years.  The  table  also  shows  how  rapid 
is  the  accumulation  in  the  depreciation  reserve  of  the  steel 
corporation  owing  to  the  fact  that  the  payments  out  of  these 
funds  have  as  yet  been  small.  In  seven  years  the  amount  in 
these  reserves  has  more  than  doubled.  The  company  is  ac- 
cumulating large  reserves  against  the  day  when  it  will  be 
necessary  for  it  to  re-equip  its  plants. 


CHAPTER    XYII 

FIXING  THE  PROPORTION  OF  PROFITS  TO  BE  PAID  OUT 
IN   DIVIDENDS 

The  third  rule  or  principle  which  we  find  to  govern  the 
dividend  policy  of  well-managed  companies  is  to  pay  out  in 
cash'^dividends  only  a  portion  of  the  balance  of  income  re- 
maining in  any  year  available  for  distribution  to  stockholders. 
Even  after  a  large  surplus  has  been  accumulated  to  safeguard 
the  dividend  rate,  and  with  the  most  careful  management  of 
the  depreciation  and  renewal  accounts,  the  amount  of  this 
"balance  for  dividends"  is  subject  to  wide  fluctuations, 
which,  in  view  of  the  desirability  of  maintaining  a  fixed 
rate  of  dividend,  makes  the  distribution  of  the  entire  amount 
in  any  year  unwise. 

The  earnings  of  a  corporation  are  the  resultant  of  three 
factors:  (1)  The  volume  of  traffic  or  sales;  (2)  the  rate 
or  price  at  which  the  business  is  done;  (3)  the  cost  of  opera- 
tion or  production.  A  steel  manufacturing  company,  for 
example,  buys  coke,  pig  iron  and  limestone  and  converts 
these  products  first  into  iron,  and  then  into  steel  rails  by 
purchasing  the  services  of  a  number  of  employees,  and  finally 
sells  the  product  to  the  consumer.  The  formula  for  calculat- 
ing the  profits  of  this  company  is  as  follows:  (Receipts  from 
sales)  —  !(cost  of  materials)  -f-  (wages,  salaries  and  general 
expenses)  +  (interest,  rentals  and  taxes)  -|-  (cost  of  ma- 
terials, machinery  for  replacements  and  new  construction 
charged  to  depreciation ).\  A  variation  in  any  of  the  items 
of  expenses,  unless  accompanied  by  corresponding  variation 
of  receipts,  will  result  in  a  fluctuation  of  profits. 
226 


FIXING   PROPOKTION   OF   PROFITS  227 

Stability  of  profits,  under  these  circumstances,  is  an  im- 
possibility. The  price  of  the  product  changes  with  the  period- 
ical fluctuations  of  demand.  The  growing  power  of  organ- 
ized labor  as  well  as  the  inefficiency  of  labor  when  employment 
is  plentiful,  makes  labor  cost  uncertain.  New  inventions 
and  improvements  may  require  the  company  to  discard  large 
amounts  of  machinery.  Only  the  items  of  general  expense 
and  interest  charges  can  be  regarded  as  factors  of  expense 
which  can  be  reckoned  with  certainty.  On  the  other  hand, 
the  receipts  from  sales  are  even  more  uncertain.  In  Sep- 
tember, 1907,  for  example,  few  anticipated  that  within  three 
months  the  leading  manufacturing  plants  of  the  country 
would  be  operating  at  one  half  of  their  normal  capacity. 
The  regular  alternations  of  prosperity  and  depreciation,  to 
say  nothing  of  general  breakdowns,  such  as  befell  the  steel 
industry  in  1908,  or  difficulties  with  organized  labor,  or 
advances  of  freight  rates  or  tariff  changes,  any  one  of  these 
uncertainties  may  come  in  to  make  a  marked  change,  both 
in  prices  and  the  volume  of  sales.  Here  are  two  sets  of  profit 
variables,  one  disturbing  calculations  of  expense,  the  other 
calculations  of  income.  As  a  result  of  their  interaction, 
every  industry  is  subject  to  excessive  variations  of  profits. 

We  may  illustrate  from  reports  of  the  Baltimore  &  Ohio.' 
The  gross  earnings  of  this  company  increased  from  67.6 
millions  in  1905  to  82.2  millions  in  1907.  Then  came  the 
panic  and  the  depression,  which  reduced  gross  earnings  to 
73.6  millions.  Operating  expenses,  from  1905  to  1907,  in- 
creased only  ten  millions.  As  a  result,  the  net  earnings  of 
the  company,  the  difference  between  gross  earnings  and  oper- 
ating expenses,  increased  nearly  five  million  dollars.  On 
the  other  hand,  from  1907  to  1908,  operating  expenses  were 
hardly  reduced  at  all,  standing  at  fifty-four  millions  each 
year.  Net  earnings  from  operation  of  the  Baltimore  &  Ohio 
declined  from  twenty-seven  millions  to  nineteen  millions,  the 
exact  amount  of  the  decrease  in  gross  earnings,  in  con- 
sequence. 


228  CORPORATION  FINANCE 

These  fluctuations  in  profits  are  even  more  serious  in  the 
case  of  industrial  corporations.  For  example,  the  American 
Smelting  &  Refining  Company  reported  gross  earnings  of 
13.2  millions  in  1907,  and  9.4  millions  in  1908,  and  the 
net  earnings  from  operation  of  the  United  States  Steel  Cor- 
poration which  were  161  millions  in  1907  to  which  figure 
they  had  increased  from  119.7  millions  in  1905,  suffered  a 
decline  of  approximately  forty  per  cent  during  1908,  falling 
to  91.8  millions.  This  fluctuation  of  profits  is  not  the  same 
for  all  industries,  nor  is  the  rate  of  change  the  same  for 
every  corporation  in  each  industry.  Tlie  distinction  between 
industries,  in  respect  to  the  relative  stability  of  their  profits, 
we  shall  have  present  occasion  to  examine.  For  the  time 
being,  it  is  sufficient  to  note  that  these  profit  fluctuations  do 
exist,  and  that  they  must  be  reconciled  with  the  necessity  of 
paying  the  regular  dividend. 

In  view  of  these  irregular  earnings,  it  is  impossible  for 
corporation  directors  to  pay  out  all  their  earnings  to  stock- 
holders without  making  dividends  unstable  and  damaging 
the  financial  standing  of  the  company.  To  reconcile  the 
necessity  for  stable  dividends  with  the  fact  of  unstable  profits, 
the  directors  must  pay  out  only  such  a  percentage  of  profits 
as  will  leave  a  margin  over  the  dividend  requirements,  assum- 
ing profits  to  fall  to  the  lowest  point  which,  in  all  reason- 
able probability,  will  be  reached.  A  corporation  should  ascer- 
tain from  its  own  experience,  and  from  the  experience  of 
other  companies  similarly  situated,  what  are  likely  to  be  the 
lowest  earnings  under  the  most  unfavorable  circumstances 
which  it  is  likely  to  encounter,  and  then  fix  its  dividend  rqj;e 
well  below  that  point.  In  order  to  maintain  a  stable  rate  of 
dividend,  a  corporation  should  have  its  maximum  dividend 
requirement  always  fall  below  its  smallest  earnings.  If  the 
opposite  policy  is  adopted,  large  dividends  will  be  paid  out 
of  large  profits,  small  dividends  out  of  small  profits,  and 
the  value  of  the  stock,  as  already  explained,  will  be  low  and 
uncertain. 

Our   next   question   concerns    the   percentage    of  profits 


FIXING   PROPOKTION   OF   PROFITS  229 

which  directors,  having  regard  to  the  desirability  of  a  stable 
dividend  rate,  can  safely  pay  out  to  stockholders.  The  deter- 
mination of  this  proportion  is  a  matter  for  the  judgment  of 
directors  in  each  case  to  determine,  having  regard  to  the 
peculiar  circumstances  of  their  own  company.  There  are, 
however,  certain  broad  considerations  on  the  basis  of  which 
a  classification  of  companies,  with  reference  to  the  proportion 
of  surplus  earnings  which  should  be  paid  to  stockholders, 
can  be  made. 

The  percentage  of  average  profits  which  can  safely  be 
paid  out  to  stockholders  varies  with  the  regularity  of  its 
profits.  To  illustrate:  a  corporation,  the  difference  between 
whose  maximum  and  minimum  profits  over  a  period  of  years 
is  fifty  per  cent,  should  pay  out  only  half  the  proportion  of 
annual  earnings  which  can  be  safely  distributed  by  another 
corporation  whose  earnings  fluctuate  only  twenty-five  per 
cent. 

The  stability  of  the  earnings  of  a  corporation  depends 
primarily  upon  the  demand  for  the  product  or  service  which 
it  supplies.  In  manufacturing  industry,  this  stability  of 
demand  is  greatest  in  those  corporations  which  produce  the 
necessaries  of  life,  such  as  sugar,  oil  and  flour,  and  it 
declines  as  the  article  becomes  less  indispensable  to  the  con- 
sumer. The  percentage  of  average  earnings  which  a  lace 
or  glove  manufacturing  company,  for  example,  can  safely 
pay  to  its  stockholders  is  far  less  than  that  which  a  sugar 
or  oil  company  produces.  The  fluctuations  in  the  demand 
for  all  goods  used  in  production,  including  machinery  and 
materials,  are  also  great.  Iron  and  steel  products,  for  ex- 
ample, are  purchased  that  the  buyer  may  make  a  profit 
by  using  these  commodities  in  further  production.  Such 
articles  as  lathe,  steel  rails  and  structural  steel  are  usually 
bought  by  producers  who  expect  to  make  a  profit  by  using 
them  or  reselling  them.  The  strength  of  the  demand  for 
iron  and  steel  depends,  therefore,  upon  the  movement  of 
profits. 

As  a  general  principle,  rising  prices  always  mean  advanc- 
46 


230  COKPORATION   FINANCE 

ing  profits  to  the  industries  concerned,  and  falling  prices 
mean  declining  profits.  The  reason  for  this  is  that  costs  of 
production  move  more  slowly  than  prices  of  the  product, 
since  they  contain  certain  elements  such  as  wages  and  inter- 
est, which  change  very  slowly.  Industries  are,  moreover,  so 
closely  joined  together  in  the  relations  of  producer  and  con- 
sumer that  an  increase  in  the  prices  and  profits  of  one 
industry  is  quickly  passed  to  the  others.  When  the  price  of 
wheat,  for  example,  is  rising,  the  farmer's  profits  go  up,  and 
with  them  his  demand  for  agricultural  implements,  barbed 
wire,  and  nails.  When  the  price  of  wheat  falls,  these  pur- 
chases are  postponed  to  a  more  convenient  season.  Eising 
prices  increase  the  volume  of  traffic,  the  earnings  of  the  rail- 
roads, and  the  prices  of  their  securities,  enabling  them  to 
raise  money  for  extensions  and  improvements,  which  improves 
the  demand  for  a  great  variety  of  articles  entering  into  the 
construction  and  equipment  of  railroads.  On  the  other  hand, 
when  prices  are  falling,  and  the  volume  of  business  shrinks, 
railway  earnings  decline,  the  security  market  will  take  only 
high-grade  bonds,  and  these  only  at  low  prices,  the  railroads 
have  no  margin  in  their  earnings  to  make  improvements, 
and  their  securities  cannot  be  sold  to  advantage.  It  is  then 
necessary  to  stop  their  extension  and  improvement  work,  and 
to  curtail  their  expenditures  for  materials.  The  same  in- 
fluence determines  the  demand  for  the  products  of  all  the 
metal  industries,  and  also  the  demand  for  such  articles  as 
coal  and  lumber  which  are  purchased  for  profit  and  not  for 
the  personal  consumption  of  the  buyer.  The  demand  for 
these  articles  fluctuates  widely  and  often  wildly,  correspond- 
ing to  the  alternations  of  business  prosperity  and  business 
depression.  Industries  which  produce  production  goods,  there-/ 
fore,  if  properly  managed,  will  be  very  conservative  in  theirf 
distribution  of  profits  to  stockholders. 

There  is  a  wide  difference  between  the  profits  of  railway 
transportation  companies  and  manufacturing  companies^  the 
instability  of  whose  profits  we  have  just  been  considering. 
The  demand  for  the  products  of  a  single  industry  is  limited 

/ 


FIXING   PROPOKTION   OF   PROFITS  231 

to  a  small  portion  of  the  total  number  of  commodities  pro- 
duced. The  demand  for  railway  transportation,  on  the  other 
hand,  is  represented  by  every  commodity  of  commerce.  The 
demand  for  transportation  corresponds  to  the  supply  of  com- 
modities. The  broader  is  the  demand  for  the  products  or 
service  of  an  industry,  the  more  stable  are  its  earnings, 
large  and  diversified  demand  is  but  slightly  affected  by  any 
influence,  but  if  this  influence  is  left  to  operate  by  itself 
upon  the  price  of  a  commodity  or  service,  it  produces  wide 
fluctuations.  The  withdrawal  of  ten  thousand  gallons  from 
a  standpipe  appreciably  affects  the  level  of  water  in  the  pipe. 
Withdraw  the  same  amount  from  the  reservoir,  and  the  water 
level  is  scarcely  affected.  This  analogy  may  be  applied  to 
explain  the  stability  of  the  demand  for  railway  transporta- 
tion as  compared  with  the  demand  for  coal,  sugar,  or  iron. 
The  railroad  company  is  patronized  by  the  producers  of  every 
commodity.  What  it  loses  in  freight  earnings  from  a  decline 
in  price  or  supply  of  one  group  of  products,  is  often  more 
than  regained  by  advances  in  others.  The  manufacturing 
company,  on  the  other  hand,  by  producing,  at  the  most,  only 
a  small  number  of  products,  has  usually  less  compensation 
for  a  decrease  in  demand.  Its  earnings  usually,  therefore, 
show  a  larger  effect  from  a  fall  in  prices. 

The  classified  freight  traffic  of  the  Pennsylvania  Railroad, 
for  example,  includes  thirty-six  general  classes  of  freight, 
some  of  which  comprise  thousands  of  individual  articles,  and 
each  one  of  which  contributes  to  the  $153,564,528  of  gross 
earnings  which  the  company  earned  in  1909.  Each  one  of 
these  commodities  is  acted  on  by  a  variety  of  influences  which 
affect  its  demand  or  supply,  and  which,  through  these  factors, 
influence  the  profits  of  its  producers.  The  production  of 
anthracite  coal  is  reduced  by  a  strike.  As  a  result  the  de- 
mand for  bituminous  coal  is  increased.  A  failure  of  the  corn 
crop  reduces  the  profits  of  the  farmer  and  rancher.  A  cut 
in  duties  decreases  the  profits  of  the  manufacturer,  and  a 
change  in  internal  revenue  duties  affects  the  profits  of  the 
grower  and  distiller.    Prices  and  profits  are  in  a  state  of  con- 


232  COKPOKATION   FINANCE 

stant  change.    No  manufacturing  industry  can  be  certain  of 
its  earnings  a  year  hence. 

From  these  disturbing  influences,  however,  the  railway 
company  is,  to  a  large  extent,  protected.  The  great  variety 
of  its  traffic  prevents  rapid  changes  in  the  gross  amount. 
What  is  lost  on  one  commodity  is  often  regained  on  another, 
and  the  total  tonnage  is  not  reduced.  This  is  well  illustrated 
by  a  comparison  of  the  gross  earnings  of  the  Pennsylvania 
Eailroad  with  those  of  the  United  States  Steel  Corporation. 
The  one  is  the  largest  railroad  system  in  the  United  States 
and  one  of  the  best  managed,  and  the  other  is  the  largest  and 
one  of  the  best-managed  and  best-organized  industrials.  The 
steel  corporation,  moreover,  manufactures  a  great  variety  of 
products,  so  that  its  demand  would  naturally  be  more  stable 
than  those  of  steel  manufacturing  companies  whose  profits 
are  more  narrowly  specialized.  It  has  also  been  able  to  main- 
tain for  long  periods  stable  prices  for  most  of  its  products, 
and  its  supremacy  in  the  steel  trade  since  its  organization 
has  only  recently  been  challenged.  Competition,  until  the 
winter  of  1909,  has  very  slightly  disturbed  it,  and  yet  the 
fluctuation  of  its  gross  earnings,  compared  with  the  Pennsyl- 
vania Eailroad,  which  appears  in  the  following  table,  where 
the  figures  are  stated  in  millions  of  dollars,  is  extreme.  The 
figures  for  the  Pennsylvania  Eailroad  are  as  follows,  stated  in 
millions  of  dollars: 

1902 112 

1903 122 

1904 /. 118 

1905 133 

1906 148 

1907 164 

1908 136 

and  for  the  United  States  Steel  Corporation  as  follows : 

1902 500 

1903 536 

1904 444 

1905 585 

1906 696 

1907 757 

1908 482 


FIXING   PKOPORTION   OF   PROFITS 


233 


The  percentages  of  fluctuation  from  one  year  to  another  in 
the  two  companies  are  as  follows : 


Pennsylvania 
Railboad. 

United  States 
Steel  Cor- 
pobation. 

1902                           

15.15 
8.93 
3.28 
12.71 
11.28 
10.81 
17.08 

1903 

7.20 

1904 

17.16 

1905 

31.76 

1906           

18.97 

1907 

8.76 

1908 

36.33 

Broadly  speaking,  the  distinction  which  has  been  indi- 
cated between  railway  and  manufacturing  industries  holds 
good  wherever  it  is  applied.  The  demand  for  the  transporta- 
tion services  offered  by  some  railways,  especially  those  which 
depend  exclusively  upon  iron  and  steel  or  kindred  industries, 
is  more  irregular  than  those  of  some  manufacturing  compa- 
nies— for  example,  gas  or  electric  lighting  companies  or  com- 
panies supplying  certain  food  products  which  are  regarded  as 
necessaries  of  life.  But  as  between  the  two  classes  of  cor- 
porations, railroads  and  industrials,  the  comparison  of  sta- 
bility of  demand  favors  the  railroad,  primarily  because  of  the 
breadth  of  the  demand  for  its  products. 

The  distinction  between  transportation  and  manufactur- 
ing industry,  on  the  basis  of  the  respective  stability  of  their 
profits,  is  explained,  not  merely  by  varying  conditions  of  de- 
mand, but  by  their  respective  liability  to  competition.  A 
business  in  which  competition  prevails  is  certain  to  be  a  busi- 
ness of  fluctuating  prices.  When  demand  is  slack,  the  sell- 
ers, in  their  struggle  to  keep  their  plants  in  operation  and 
their  organizations  employed,  give  the  buyer  concession  after 
concession,  which  he  very  well  knows  how  to  extract  by  play- 
ing one  seller  against  another.  Then,  when  business  revives, 
the  producer,  who  has  usually  lost  money  during  the  depres- 
sion, takes  immediate  and  full  advantage  of  the  opportunity 
to  charge  the  highest  price  which  the  traflBc  will  bear.    These 


234  COKPOKATION   FINANCE 

high  prices,  as  soon  as  the  low-price  contracts  with  which 
large  consumers  have  protected  themselves  expire,  lead  to  the 
curtailment  of  demand  and  to  another  outbreak  of  competi- 
tion. When  the  steel  industry,  for  example,  was  a  competi- 
tive business,  prices  were  highly  irregular.  In  fact,  for  a 
long  period  there  were  no  fixed  prices  on  account  of  the 
rebates  and  discriminations;  everything  was  uncertain,  irreg- 
ular, and  unstable.  Under  such  conditions  profits  were  not 
only  reduced  in  the  aggregate,  but  their  fluctuations  were 
enormous.  From  1901  to  1909,  however,  under  the  domi- 
nance of  the  United  States  Steel  Corporation,  which  has 
controlled  about  sixty  per  cent  of  the  production  of  finished 
material,  and  of  whose  power  the  smaller  producers  have 
stood  in  awe,  stable  prices  have  been  maintained.  The  cor- 
poration has  neither  raised  prices  during  periods  of  active 
demand — for  example,  in  1904,  1905,  1906,  and  1907,  when 
they  could  have  materially  advanced  quotations — nor  when 
business  declined  have  they  attempted  the  futile  experiment 
of  persuading  the  manufacturer  half  of  whose  plant  is  idle, 
or  a  railroad  with  one  third  of  its  equipment  on  the  sidings, 
to  invest  large  sums  in  steel  products  for  extensions  and  im- 
provements by  making  concessions  in  price.  By  maintaining 
prices  they  have  earned  a  larger  margin  of  profits  on  a  re- 
duced tonnage,  and  have  protected  their  interest  and  pre- 
ferred dividends. 

From  the  influence  of  competition,  the  profits  of  the  rail- 
way industry  are  almost  fully  protected.  The  railway  com- 
pany enjoys  a  natural  monopoly.  After  the  territory  through 
which  its  lines  pass  has  been  fully  settled,  and  the  local  dona- 
tions of  land  and  cash,  upon  which  most  American  railways 
originally  depended  for  their  construction,  have  ceased,  the 
building  of  competing  lines  becomes  very  difficult.  An  im- 
portant deterrent  to  new  railroad  construction  is  the  increas- 
ing cost  of  terminals.  A  recent  illustration  of  this  fact  is  the 
enormous  expenditures  of  the  Gould  interests  to  put  a  line 
into  Pittsburg,  which  it  is  claimed  cost  them  $30,000,000, 
and  which,  because  of  their  inability  to  connect  with  the  lead- 


FIXING  PKOPOKTION   OF   PKOFITS  235 

ing  industries  of  that  city,  and  also  because  of  the  absence  of 
an  Eastern  outlet  which  would  enable  them  to  compete  for  the 
bulk  of  the  tonnage,  has  never  been  successful.  Even  where 
competition  exists  between  the  larger  cities,  the  local  traffic 
is  generally  free  from  this  influence,  and  competition  for 
through  business,  while  effective  in  maintaining  lower  rates 
between  competitive  points,  is  nevertheless  well  regulated  by 
uniform  agreements,  which  are  well  observed,  presumably 
because  the  decline  of  traffic  during  periods  of  depression  is 
not  so  severe  as  to  incite  a  struggle  for  existence  between 
railroads,  and  also  because  all  forms  of  secret  rate  cutting, 
rebating,  and  discriminations  are  now  prohibited  by  a  Fed- 
eral criminal  statute,  which  has  been  rigidly  enforced  in 
recent  years. 

A  few  years  ago  the  attempt  was  made  to  permanently 
eliminate  competition  in  the  railway  field  by  a  system  of 
community  of  interest  by  which  one  road  purchased  control, 
although  not  always  a  majority  interest,  in  the  stocks  of  its 
competitors.  This  system  has  been  broken  up  by  the  enforce- 
ment of  the  Sherman  Antitrust  Law,  but  it  lasted  long 
enough  to  enforce  upon  the  railroads  the  necessity  of  agree- 
ment upon  rates.  While  railway  competition,  so  far  as  it  re- 
lates to  speed  and  character  of  service,  still  exists,  competi- 
tion in  rates  has  practically  disappeared. 

The  elimination  of  competition  from  manufacturing  in- 
dustry, however,  is  exceedingly  difficult.  To  return  again  to 
the  United  States  Steel  Corporation,  which  offered  the  best 
promise  of  accomplishing  this  result,  we  find  that,  during  the 
winter  of  1909,  this  attempt  to  control  prices,  although  it 
was  for  the  manifest  interest  of  the  trade,  was  completely 
broken  down.  The  steel  corporation  at  no  time  controlled 
two  thirds  of  the  steel  production  of  the  United  States,  but 
relied  upon  its  control  of  raw  materials  and  the  influence 
which  the  dominant  factor  in  the  trade  usually  has  upon 
the  weaker  members,  to  secure  adherence  to  a  policy  of  fixed 
prices.  By  uniting  upon  this  policy,  the  small  amount  of 
business  which  was  to  be  had  was  handled  at  remunerative 


236  COKPORATION   FINANCE 

prices,  and  the  profits  of  all  steel  producers  were  much  larger 
than  they  would  have  been  had  they  surrendered  to  the  con- 
sumer at  the  outset  of  the  depression.  Little  by  little,  how- 
ever, under  the  pressure  of  necessity,  the  independents  broke 
away  from  the  agreement,  and  cut  prices  in  order  to  secure  a 
larger  share  of  the  limited  business  available  than  they  would 
have  obtained  had  they  followed  the  policy  of  the  steel  cor- 
poration in  maintaining  prices.  At  last  this  price  cutting 
was  seen  to  threaten  the  steel  corporation  with  the  loss  of 
most  of  its  business  for  the  coming  year.  In  self-defense  it 
was  compelled  to  announce  an  open  market  for  steel.  With 
this  declaration,  a  portion  of  the  benefits  of  combination,  so 
far  as  these  relate  to  the  control  of  prices,  were  surrendered  to 
the  consumer. 

The  failure  of  the  attempt  of  the  United  States  Steel 
Corporation  to  control  prices,  an  attempt  made  under  the 
most  favorable  auspices,  with  the  strongest  leadership,  and 
apparently  with  the  cordial  cooperation  of  all  members  of  the 
trade,  shows  that  the  maintenance  of  stable  prices  in  the  field 
of  production  goods,  unless  the  ownership  of  an  entire  in- 
dustry can  be  secured  by  one  producer,  is  difficult.  Single 
ownership  the  Federal  and  State  laws,  as  at  present  inter- 
preted, will  not  permit. 

In  the  field  of  consumption  goods,  where  commodities  are 
purchased  directly  by  the  consumer,  monopoly  is  even  more 
difficult  to  secure.  The  concentration  of  manufacture  under 
the  control  of  large  corporations  has  worked  for  a  larger 
measure  of  stability  than  was  possible  when  an  industry  was 
carried  on  by  a  large  number  of  productive  units,  but  com- 
bination has  thus  far  done  no  more  than  to  mitigate  the 
severity  of  competition.  It  has  not  been  able  to  do  away 
with  competition. 

These  general  differences  between  industries,  however,  do 
no  more  than  furnish  the  starting  point  for  the  determina- 
tion of  the  percentage  of  profits  which  a  given  corporation 
can  carry.  Within  each  industry,  a  great  diversity  of  condi- 
tions as  to  the  strength  of  demand,  costs  of  production,  con- 


FIXING  PKOPORTION   OF   PROFITS  237 

trol  of  raw  materials,  location  in  reference  to  markets,  and 
a  variety  of  other  considerations  are  encountered.  The  exist- 
ence of  these  differences  in  conditions  makes  it  impossible, 
without  reference  to  the  circumstances  of  the  corporation  in 
question,  to  determine  the  proportion  of  average  profits  which 
can  safely  be  distributed  to  stockholders. 

Even  within  the  industry  whose  profits  are  more  stable 
than  any  other,  the  business  of  railway  transportation,  we 
find  wide  differences  between  the  stability  of  profits  of  differ- 
ent railroads.  The  New  England  railroads — for  example, 
the  New  York,  New  Haven  &  Hartford  and  the  Boston  & 
Maine — have  a  large  percentage  of  passenger  traffic  which 
fluctuates  little,  and  a  high-class  traffic  of  manufacturing 
goods  and  merchandise,  which  produces  a  stable  revenue.  In- 
dustrial conditions  in  this  territory  are  very  stable.  The  peo- 
ple, as  a  community,  are  well-to-do,  and  the  New  England 
States  are  affected  in  a  much  smaller  degree  by  an  industrial 
depression  than  are  many  other  communities.  As  a  result  of 
these  conditions,  the  traffic  and  earnings  of  the  New  York, 
New  Haven  &  Hartford  and  the  Boston  &  Maine  are  subject 
to  relatively  slight  fluctuations.  These  companies  can  and  do 
pay  out  a  larger  percentage  of  profits  to  stockholders  than 
can  be  safely  distributed  by  such  companies  as  the  Pennsyl- 
vania and  the  Baltimore  &  Ohio,  both  of  which  depend  mainly 
on  the  coal  and  iron  and  steel  traffic,  or  by  the  Granger  lines, 
whose  principal  reliance  is  still  on  the  products  of  agriculture. 

But  while  it  is  impossible,  for  the  reasons  stated,  to  indi- 
cate, as  between  different  industries,  the  percentages  of  prof- 
its which  can  be  safely  distributed  in  dividends,  we  may  an- 
swer the  question  as  to  the  proper  amount  of  earnings  which 
should  be  reserved  for  the  protection  of  the  dividend  rate 
by  reference  to  the  practice  of  the  most  conservative  railway 
and  industrial  companies.  The  Pennsylvania  Railroad,  for 
example,  on  an  average  of  many  years,  has  made  it  a  rule 
that  for  every  dollar  paid  out  in  dividends  another  dollar 
shall  be  put  into  the  property.  The  Chicago  &  Northwestern 
has  distributed  about  three  fourths  of  its  profits;  the  Great 


f 


238  CORPOKATIONVFINANCE 

Northern,  a  somewhat  smaller  percentage.  The  earnings  of 
the  railway  business,  with  the  possible  exception  of  public 
service  corporations  located  in  a  few  of  the  larger  cities,  are, 
as  we  have  seen,  more  permanent  and  stable  than  those  of  any 
other  leading  industry.  In  fixing  the  percentage  of  reserve 
required  for  corporations  operating  in  industries  where  the 
stability  of  profits  is  less  than  in  the  railway  industry,  it  is 
safe  to  require  at  least  as  large  a  proportion  as  that  reserved 
by  the  strongest  railway  companies,  since  the  nature  of  the 
railway  business  renders  the  earnings  of  long-established  rail- 
way companies  far  more  stable  than  the  profits  of  even  those 
manufacturing  companies  which  are  most  firmly  intrenched 
in  the  control  of  raw  materials  and  in  a  stable  demand  for 
their  product. 

On  the  basis  of  this  principle,  we  may  assume  that  no 
railroad  company,  outside  of  corporations  so  exceptionally 
situated  as  are  the  railroads  in  Southern  New  England,  can 
safely  pay  out  in  dividends,  on  ,an  average  of  ten  years,  more 
than  three  fourths  of  its  profits^^and  that  the  percentage  of 
cash  distributed  by  industrial  corporations  should  not  be  more 
than  fifty  per  cent  of  the  average  profits.  The  implication  of 
this  rule  is,  of  course,  that  during  periods  of  large  profits  a 
much  higher  percentage  than  fifty  per  cent  must  be  reserved 
for  the  stock.  As  a  general  proposition,  a  corporation  which 
follows  the  rule  of  a  dollar  for  the  company  and  a  dollar  for 
the  stockholder  is  on  the  way  to  ac  investment  position  for 
its  stock.  In  cases  where  the  industry  is  exposed  to  excep- 
tionally wide  fluctuations  of  profits  even  a  larger  percentage 
must  be  reserved.  The  balance  reserved  for  the  company  is 
invested  for  its  benefit,  the  accumulation  of  this  annual  in- 
vestment raising  the  earning  capacity  of  the  company  so  that 
a  higher  dividend  rate  can  eventually  be  paid.  As  the  divi- 
dends increase,  however,  the  surplus  should  also  increase, 
both  dividends  and  surplus,  with  ordinary  good  management, 
moving  upward,  and  the  stockholders  profiting,  not  merely 
from  the  increase  in  dividends,  but  from  their  greater  se- 
curity in  any  rate  of  dividend  once  attained. 


CHAPTER    XVIII 
THE  METHODS  OF  DISTRIBUTING  THE  SURPLUS 

What  now  is  the  relation  of  this  surplus  appearing  on  the 
balance  sheet  to  the  rate  of  dividend  ?  May  it  be  drawn  upon 
in  case  of  emergency  to  make  up  a  deficit  in  income?  May 
it  be  distributed  in  large  amounts  as  special  dividends  to 
stockholders,  or  can  the  stockholders  hope  for  no  greater  ben- 
efit from  this  accumulation  out  of  profits  than  their  propor- 
tion of  the  addition  which  will  be  made  to  the  income  of  the 
company  as  a  result  of  the  investment  of  its  profits  ?  In  the 
majority  of  companies  the  only  service  which  the  surplus  | 
accumulated  out  of  profits  renders  to  the  dividend  rate  is  to| 
increase  the  amount  of  annual  profits,  which  furnishes  the  ' 
basis  for  the  amount  of  dividends  declared.  It  may,  how- 
ever, in  some  cases  serve  as  a  fund  out  of  which  deficits  in 
the  amount  necessary  to  pay  the  regular  dividend  may  be 
made  up,  either  by  direct  withdrawal  or  by  borrowing.  The 
surplus  may  also,  from  time  to  time,  be  directly  distributed 
to  stockholders,  in  a  lump  sum,  as  a  special  dividend.  These 
various  methods  of  utilizing  the  surplus  we  have  now  to  ex- 
amine. 

The  surplus  of  a  corporation  may  be  used  as  a  source  of  J 
dividends  to  its  stockholders,  aside  from  its  service  in  increas- 
ing the  net  earnings  of  the  business,  in  the  following  ways :  ^ 
The  company  may,  during  a  season  of  depression,  draw  down 
its  surplus  by  reducing  its  cash  working  capital  for  the  pur- 
pose of  making  up  a  temporary  deficiency  in  revenue.  It  may 
accomplish  the  same  result  by  negotiating  a  temporary  loan) 
which  will  be  returned  out  of  the  income  of  a  later  period  of 

239 


240  COKPOEATION   FINANCE 

the  year.  This  method  of  borrowing  money  to  meet  divi- 
dends, when  receipts  are  irregularly  distributed  throughout 
the  year,  is  very  common.  It  is  a  legitimate  practice.  If 
the  revenues  are  in  sight,  a  bank  will  lend  money  to  a  cor- 
poration to  anticipate  those  revenues,  no  matter  if  the  pro- 
ceeds of  the  loan  are  to  be  immediately  distributed  to  the 
stockholders  in  the  form  of  a  dividend. 
7^  The  second  method  of  distributing  surplus  directly  to  the 
stockholders  is  when  a  company  may  have  acquired  in  the 
course  of  its  business  certain  assets  with  which  it  can  readily 
dispense,  such,  for  example,  as  coal-mining  or  express  com- 
panies, or  land  companies.  The  stocks  representing  these 
concerns  may  be  held  in  the  treasury  of  the  parent  company, 
and  the  dividends  received  on  these  stocks  may  be  added  to 
the  other  income  of  the  parent  company,  and  merged  into  its 
general  surplus  available  for  distribution.  In  case  it  is  expe- 
dient or  convenient  for  the  corporation  to  divest  itself  of  the 
control  of  these  properties,  the  stocks  or  bonds  issued  by  the 
subsidiary  companies  may  be  distributed  to  the  stockholders 
of  the  parent  company  as  a  special  dividend. 

An  illustration  of  this  method  is  furnished  by  the 
distribution  of  the  Great  Northern  Ore  securities  by  the 
Great  Northern  Eailway  Company  to  its  stockholders.  Cer- 
tain iron-ore  lands  in  Minnesota  had  been  acquired  in  the 
interest  of  the  Great  Northern  Eailway  by  Mr.  James  Hill, 
then  its  president,  and  his  associates.  These  properties,  ag- 
gregating about  60,000  acres,  were  located  in  the  Missabe  dis- 
trict of  Minnesota.  They  were  controlled  by  the  corporation 
known  as  the  Lake  Superior  Company,  Ltd.,  controlled  by 
the  Great  Northern  Eailway.  The  properties  were  trans- 
ferred in  the  autumn  of  1906  to  Mr.  James  J.  Hill,  Louis  W. 
Hill,  and  E.  T.  Nichols,  as  trustees,  and  1,500,000  shares  of 
permanent  beneficial  interest  in  the  trust  were  issued  in  De- 
cember, 1906,  to  the  Great  Northern  stockholders.  In  Au- 
gust, 1906,  a  lease  was  executed  to  the  Great  Western  Mining 
Company,  guaranteed  by  the  United  States  Steel  Corpora- 
tion, covering  39,295  acres  of  this  land.    The  Great  Western 


METHODS    OF   DISTRIBUTING   SURPLUS     241 

Mining  Company  agreed  to  extract  750,000  tons  of  ore  in 
1907,  with  an  increase  of  750,000  tons  annually,  until  a  max- 
imum annual  extraction  of  8,250,000  tons  was  reached  in 
1917.  The  lease  fixes  the  royalty  for  each  ton  of  ore  deliv- 
ered at  the  dock  by  the  Great  Northern  at  $1.65,  and,  after 
deducting  eighty  cents  per  ton  as  freight  to  the  railroad  com- 
pany for  transporting  the  ore,  the  balance  is  distributed  to 
the  holders  of  trust  certificates  at  least  once  a  year.  These 
certificates  were  immediately  distributed  by  the  Great  North- 
ern to  its  stockholders  as  a  special  dividend. 

It  has  long  been  the  policy  of  the  Great  Northern  to  keep 
Its  dividend  at  seven  per  cent.  Had  it  retained  these  ore 
certificates  in  its  treasury  and  paid  the  rentals  in  the  regular 
dividends,  this  rate  would  have  been  exceeded.  The  lease  pro- 
tected the  railway  company  in  the  transportation  of  the  ore 
to  be  mined  under  the  lease.  .It  could,  therefore,  without 
danger  of  losing  control  of  this  traffic,  distribute  the  certifi- 
cates of  beneficial  interest  in  the  lease  as  a  special  dividend  to 
the  stockholders.  This  was  a  direct  distribution  of  its  sur- 
plus by  the  Great  Northern  Railroad  Company. 

[A  portion  of  the  surplus  may  be  annually  set  aside  into  a 
dividend,  reserve  fund,  withdrawn  from  the  working  capital 
of  the  business,  and  invested  in  a  form  in  which  it  can  be 
drawn  upon  without  impairing  the  efficiency  of  the  corpora- 
tion. Unless  the  dividend  reserve  fund  is  built  up  in  this 
manner,  the  assets  of  the  company  cannot  be  directly  utilized 
to  make  up  a  deficiency  in  reserve.  A  railroad  company,  for 
example,  has  invested  its  surplus  in  equipment,  or  in  improve- 
ments to  its  line,  or  in  larger  terminal  facilities,  or  in  securi- 
ties of  corporations.  It  also  carries  a  certain  cash  balance. 
It  cannot  sell  any  of  these  properties  or  assets  without  im- 
pairing its  efficiency.  The  investment  of  surplus  funds  in 
the  business  of  the  corporation  merges  and  identifies  them 
with  the  general  assets  of  the  compa'ny,  which  are  used  for  its 
general  corporate  purposes,  and  which,  unless  the  stockholder 
decides  to  wind  up  its  affairs  and  to  pay  its  debts  and  divide 
the  balance,  are  not  available  for  distribution.    If,  however. 


242  COEPOKATION  FINANCE 

a  company  adopts  the  policy  of  maintaining  a  dividend  re- 
serve fund,  it  may  utilize  its  surplus  directly  to  make  up 
deficiencies  in  revenue. 

When  a  dividend  reserve  fund  is  established,  an  amount 
is  withdrawn  each  year  from  the  working  capital  of  the  busi- 
ness, and  invested  in  securities  which  are  held  merely  as  in- 
vestments, and  which  do  not  represent  the  control  of  the  prop- 
erties necessary  to.  the  business  of  the  company.  In  a  year 
of  small  profits,  a  portion  of  these  securities  can  be  sold,  or 
they  can  be  hypothecated  for  a  loan,  and  the  regular  dividend 
can  thus  be  paid.  This  plan  is  in  effect  the  averaging  of 
payments  out  of  surplus  over  a  period  of  years — the  same 
principle  as  that  followed  by  many  companies  in  insuring 
their  own  plants. 

An  illustration  is  furnished  by  the  Cunard  Company, 
which,  over  the  twenty  years  ending  1902,  out  of  £4,650,380 
of  profits  earned,  paid  only  18.8  per  cent  to  the  owners  of 
the  company  and  added  81.2  per  cent  to  the  various  reserves 
which  the  company  maintained.  A  large  amount  of  this 
money  withheld  from  the  stockholders  was  invested  in  good 
securities,  and  during  four  bad  years,  from  1892  to  1895, 
,these  reserves  were  drawn  upon  for  dividends.  Of  the 
£64,000  which  was  paid  out  to  stockholders  during  these 
years,  £55,000  came  from  the  reserves.  The  maintenance  of 
a  dividend  reserve  fund  is  justifiable  for  corporations,  such 
as  ocean  transportation  companies,  whose  profits  are  subject 
to  wide  fluctuations.  As  a  general  proposition,  however,  the 
maintenance  of  these  funds  cannot  be  approved.  The  reason 
is  the  same  as  that  which  can  be  urged  against  maintenance 
of  linking  funds — the  fact  that  money  invested  in  securities 
can  earn  at  the  best  4^  or  5  per  cent,  while  if  invested  in  the 
business  its  earnings  are  much  larger.  A  growing  company 
has  always  need  of  new  capital  to  expand  its  business,  and 
save  in  exceptional  cases  euch  as  the  one  just  described,  it  is 
bad  policy  to  maintain  any  portion  of  its  surplus  in  a  form 
from  which  it  can  be  directly  distributed  to  the  stockhold- 
ers.    It  is  better  that  the  annual  reservations  from  profits 


METHODS    OF   DISTRIBUTING    SURPLUS     243 

should  be  merged  into  the  general  assets  of  the  company, 
since  in  this  way  they  will  contribute  to  the  increase  of  its 
profits  and  property.  •  _ 

With  the  exception  of  the  two  methods  described-^tem- 
porary  reduction  of  working  capital  or  payment  of  divid'ends 
out  of  a  dividend  reserve  fund-3direct  distribution  of  the 
accumulations  of  the  profits  of  a  "Corporation  which  have  been 
invested  in  the  enlargement  of  its  business,  is  not  possible. 
The  surplus  has  become  an  integral  part  of  the  property  of 
the  company,  merged  into  general  assets,  increasing  in  time 
the  annual  profits  in  which  stockholders  participate,  but  not 
available  as  a  fund  of  assets  for  immediate  distribution  to 
stockholders.  The  company  cannot  sell  any  part  of  its  plant 
to  pay  a  xiividend  or  dispose  of  any  securities  which  it  holds 
for  the  purpose  of  controlling  corporations  which  these  se- 
curities represent,  or  impair  its  working  capital,  in  order  to 
'make  a  distribution  to  stockholders.  The  distribution  of  the'^ 
./\  surplus  must  be  made,  if  at  all,  by  increasing  liabilities  J 
^rather  than  reducing  assets.  ^-.  ^ 

'  We  have  described  the  surplus  as  the  difference  between 
assets  and  liabilities,  which  appears  on  the  liability  side  of 
the  balance  sheet.  This  surplus  can  be  reduced  either  by 
reducing  the  assets  or  by  increasing  liabilities.  In  either  case, 
the  difference  between  assets  and  liabilities  is  reduced,  and  if 
the  corporation  issues  stock  or  bonds  directly  to  stockhold- . 
ers,  or  sells  these  securities  and  pays  out  the  proceeds  as 
special  dividends,  it  may,  without  impairing  its  general  as- 
sets or  crippling  in  any  way  the  efficiency  of  its  plant,  dis- 
tribute its  surplus  to  its  stockholders. 

An  ordinary  method  of  financing  current  requirements! 
for  new  construction  is  to  spend  upon  the  property  the! 
amount  available  for  a  dividend,  paying  the  dividend  notij 
in  cash  but  in  stock  or  scrip  redeemable  in  stock.  Cluett, 
Peabody  &  Company  are  carrying  out  an  extensive  plan 
of  providing  new  capital  by  this  method,  which  is  merely  a 
sale  of  stock  to  stockholders  at  par.  No  objection  can  be 
made  to  this  practice  so  long  as  the  amount  of  stock  paid 


244  COKPOKATION   FINANCE 

out  does  not  exceed  the  cash  dividend  which  could  safely  be 
paid  at  the  time.  / 

Corporations  occasionally,  however,  go  much  further  than 
this,  and  capitalize  the  accumulations  of  many  years  by  a 
special  dividend  in  stock  or  bonds,  or  in  cash  raised  by  the 
sale  of  securities.  A  celebrated  illustration  of  this  method 
of  distributing  surplus  is  furnished  by  the  action  of  the  Chi- 
cago &  Alton  Eailroad  Company  in  1899  in  paying  out  to 
its  stockholders  a  portion  of  its  surplus,  amounting  to  $12,- 
444,777,  which  during  previous  years,  it  was  claimed,  had 
been  taken  from  earnings  and  expended  for  additions  and 
permanent  improvements,  but  in  the  first  instance  had  been 
charged  upon  the  books  of  the  company  to  current  expendi- 
tures. The  funds  for  this  payment  were  obtained  by  a  sale 
of  bonds.  This  transaction  attracted  little  attention  at  the 
time,  but  some  years  later  was  subjected  to  severe  criticism. 

The  explanation  and  justification  of  this  transaction  by 
Mr.  Paul  D.  Cravath,  of  counsel  for  the  company,  is  as  fol- 
lows: 

All  agree  that  the  expenditures  in  question  were 
for  capital  account.  That  the  Company  had  during 
the  previous  years  devoted  at  least  $12,444,177  of  its 
profits  to  capital  expenditures  no  one  questions,  and 
that  these  expenditures  might  have  been  charged  from 
year  to  year  to  Capital  Account  and  carried  to  Surplus 
is  equally  clear.  The  witness  Hilliard,  the  present 
Comptroller  of  the  Company,  testified :  "  I  have  not 
any  doubt  that  they  might  have  been  fairly  so  charged 
at  the  time."  Mr.  Blackstone,  the  President  of  the 
Company,  in  his  annual  report  of  1894  stated  that 
the  capitalization  of  the  Company,  including  its  bonds 
and  all  obligations  assumed  by  it,  aggregated  less  than 
sixty  per  cent  of  the  actual  cost  of  the  property  in  its 
present  impaired  condition,  and  that  a  dividend  of 
eight  per  cent  is,  therefore,  the  equivalent  of  about  4f 
per  cent  upon  such  a  number  of  shares  as  would,  to- 
gether with  the  funded  debt,  represent  the  actual  cost 
of  the  property.  The  readjustment  of  accounts  was  en- 
tirely proper  and  is  sustained  by  highest  accounting 


METHODS    OF   DISTKIBUTING   SUKPLUS     245 

authority.  After  these  expenditures  for  Capital  Account 
had  from  year  to  year  been  charged  to  Current  Expense, 
the  Board  of  Directors  could  properly  and  lawfully  re- 
adjust the  accounts  and  transfer  these  expenditures  to 
Capital  Account,  thus  correspondingly  increasing  the 
Company's  surplus.  It  is  respectfully  submitted  that 
notwithstanding  the  opinion  of  the  witness  Hilliard 
to  the  contrary,  there  is  not  the  slightest  doubt  about 
the  legality  and  propriety  of  such  procedure.  This 
procedure  is  amply  supported  by  the  decisions  of  the 
courts.  A  case  precisely  in  point  is  Mills  vs.  Northern 
Ry.,  &c.,  Co.^  In  that  case  a  railroad  company  had 
for  a  considerable  period  pursued  the  practice  of  charg- 
ing the  cost  of  certain  locomotives  and  other  rolling 
stock  to  Revenue,  but,  finally,  in  order  to  increase  the 
surplus  available  for  distribution  among  the  stock- 
holders by  way  of  dividends,  the  directors  proposed  to 
readjust  the  accounts  and  transfer  these  expenditures 
from  Income  Account  to  Capital  Account,  and  to  dis- 
tribute by  way  of  dividend  among  stockholders  part  of 
the  surplus  thus  created.  Against  this  procedure  the 
plaintiff  made  precisely  the  objection  which  Mr.  Hill- 
iard has  made  against  the  similar  procedure  adopted  by 
the  Chicago  &  Alton  Railroad  Company,  but  the  High 
Court  of  Appeal  overruled  the  objection  and  said :  "  I 
have  no  hesitation  in  saying  that  the  circumstance 
that  they  had  been  paying  what  ought  to  be  charged 
to  capital  out  of  revenue  does  not  prevent  their  right 
or  their  duty  to  the  persons  who  are  looking  for  their 
payment  out  of  revenue  to  credit  back  to  revenue 
those  things  which  have  been  carried  for  the  time  to 
capital  account."  The  use  of  $6,669,180  of  the  pro- 
ceeds of  the  sale  of  the  $32,000,000  of  three  per  cent 
bonds  to  pay  a  dividend  of  thirty  per  cent  upon  the 
stock  of  the  Chicago  &  Alton  Railroad  Company, 
against  the  Company's  surplus,  most  of  which  was  the 
result  of  the  readjustment  of  accounts  discussed  in  the 
preceding  paragraph.  A  company  having  a  surplus 
may  lawfully  use  the  proceeds  of  bonds  as  a  dividend 
fund. 

As  a  readjustment  of  accounts  and  the  carrying  of 

1  Chancery  Appeals,  621  (1870). 
17 


246  COEPOKATION   FINANCE 

past  capital  expenditures  to  surplus  were  lawful,  so  it 
was  equally  lawful  to  pay  out  $6,669,180  of  that  sur- 
plus by  way  of  a  thirty  per  cent  dividend  upoa  the 
stock.  The  proposition  that  money  can  be  borrowed 
for  the  paying  of  dividends  (assuming  that  the  books 
of  the  corporation  show  a  sufficient  surplus)  is  amply 
supported  by  the  authorities. 

In  2  Cook  on  Corporations,^  Section  546,  it  is  said: 
"  When  the  company  has  used  profits  for  improve- 
ments, it  may  lawfully  borrow  an  equivalent  sum  of 
money  for  the  purpose  of  a  dividend.  And  it  may 
properly  borrow  money  to  pay  a  dividend  if,  upon  a 
fair  estimate  of  its  assets  and  liabilities,  it  has  assets 
in  excess  of  its  liabilities  and  capital  stock  equal  to  the 
amount  of  the  proposed  dividend."  It  is  difficult  to 
see  how  the  legality  of  the  dividend  can  be  questioned. 
It  is,  therefore,  only  necessary  to  discuss  its  propriety. 
The  propriety  of  a  dividend  to  represent  the  earnings 
invested  in  permanent  improvements  is  recognized  by 
the  Blackstone  management. 

In  declaring  this  dividend  the  new  management  sim- 
ply carried  out  the  purpose  of  the  old  management  as 
publicly  declared  in  the  circular  quoted  above,  except 
that  the  dividend  was  paid  in  cash  and  represented 
only  a  part  of  the  earnings  invested  in  permanent  im- 
provements, while,  apparently,  the  purpose  of  the  prior 
management  had  been  to  issue  a  stock  dividend  to 
represent  all  the  earnings  theretofore  invested  in  such 
improvements. 

As  President  Blackstone  pointed  out  in  his  annual 
report  of  1894,  such  large  amounts  of  earnings  had 
been  expended  upon  permanent  improvements  that 
the  Company's  securities  outstanding,  taken  at  their 
par  value,  represented  "  less  than  sixty  per  cent  of  the 
actual  cost  of  the  property  .  .  ."  and  while  dividends 
had  been  paid  at  the  rate  of  eight  per  cent  upon  the 
par  value  of  the  stock,  the  rate  upon  the  investment 
which  the  stock  represented — that  is,  upon  the  actual 
cost  of  the  property — was  only  4|  per  cent.  That,  of 
course,  is  the  chief  reason  why  the  common  stock  of 
the   Company  was  worth   the  price  of   $175   a  share 

1  Fifth  Edition. 


METHODS    OF   DISTEIBUTING   SURPLUS     247 

which  the  Syndicate  paid  for  it.  What  possible  impro- 
priety, therefore,  could  there  be  in  the  stockholders 
deciding  that  their  investment  in  the  stock  should  be 
reduced  by  the  payment  of  a  thirty  per  cent  dividend, 
funds  for  that  dividend  to  be  furnished  by  the  sale 
of  low  interest-bearing  bonds?  The  distribution  of  a 
stock  dividend  under  such  circumstances  is  exceed- 
ingly common.  It  is  equally  proper  to  pay  out  a 
cash  dividend  and  issue  a  reasonable  amount  of  low 
interest-bearing  bonds  for  the  purpose  of  producing 
the  cash  for  that  dividend.  This  was  not  a  case 
where  a  bare  majority  of  the  stockholders  were  forc- 
ing their  will  upon  an  unwilling  majority,  for  prac- 
tically all  of  the  stockholders  joined  in  the  declaration 
of  the  dividend,  and  all  of  the  stockholders  without 
exception  shared  in  the  distribution  of  the  dividend. 

In  the  case  which  Mr.  Cravath  describes,  the  company  is- 
sued bonds  for  cash  and  used  a  portion  of  the  cash  to  pay  the 
special  dividend  on  the  stock.  The  legality  of  this  proceed- 
ing, unless  specifically  prohibited  by  statute,  as  it  is  in  some 
States — for  example,  New  York — is  not  to  be  questioned. 
(Jrhe  surplus  could  also  be  distributed  by  an  issue  of  bonds 
direct  to  stockholders,  or  by  an  issue  of  stock,  or  a  scrip  divi- 
dend could  be  declared,  redeemable  either  in  cash  or  stock  at 
some  future  time.  All  of  these  methods  have  been  employed 
from  time  to  time  by  various  classes  of  corporations  to  dis-, 
tribute  their  surplus. 

The  expediency  of  this  practice  may  be  considered  from 
two  standpoints.  The  distribution  of  the  surplus  by  some 
scheme  of  recapitalization  involving  an  increase  of  liabilities 
without  corresponding  increase  in  assets,  and  the  turning 
over  to  the  stockholders  of  either  bonds  or  stock  or  the  pro- 
ceeds of  the  sale  of  securities,  as  a  special  dividend,  can  be 
justified  only  if  the  surplus  so  distributed  is  a  real  surplus. 
It  is  not  suificient  that  the  company  should,  from  time  to 
time,  have  reserved  large  sums  out  of  earnings  and  invested 
these  in  the  improvement  of  its  property.  These  improve- 
ments should  have  actually  added  to  the  permanent  earnings 


248  CORPORATION   FINANCE 

of  the  company.  The  issue  of  stock  or  bonds  under  these 
circumstances  means  an  increase  in  the  fixed  charges  of  the 
company,  or  in  its  dividend  requirements.  Unless  the  in- 
vestment of  profits  in  improvements  has  produced  the  requi- 
site increase  in  earnings,  or  unless  the  increase  in  earnings, 
no  matter  whence  derived,  has  been  actually  accomplished, 
a  capitalization  of  the  surplus  appearing  on  the  balance  sheet 
is  without  justification.  Aside  from  financial  expediency,  it 
is  wiser  for  a  corporation  which  has  no  surplus,  but  whose 
earnings  are  large  enough  to  pay  dividends  out  of  the  pro- 
ceeds of  stock  and  bond  sales  to  increase  its  interest  or  divi- 
dend payments,  than  for  another  corporation  whose  earnings 
are  stationary  or  declining,  but  which  has  a  large  surplus 
accumulated  out  of  earnings  standing  as  a  liability  on  its  bal- 
ance sheet.  Instances  abound  where  corporations  have  shown 
for  many  years  large  surplus  accounts  along  with  declining 
earnings.  An  excellent  illustration  of  the  disappearance  of 
a  book  surplus  is  furnished  by  the  history  of  the  Baltimore 
&  Ohio. 

This  company,  under  the  administration  of  the  Garretts, 
until  1880,  had  been  extraordinarily  prosperous.  Its  finan- 
cial position  was  strong;  it  paid  large  dividends  and  earned 
a  comfortable  margin  over  these  dividends.  Its  capital  stock 
was  small,  under  $20,000,000,  and  its  funded  debt  was  about 
$30,000,000,  showing  a  total  capitalization  of  only  $35,400  a 
mile.  Furthermore,  this  was  always  rited  as  the  best  evidence 
of  its  impregnable  position  that  its  books  showed  a  surplus  of 
$47,703,798,  representing  the  accumulations  of  investment 
out  of  earnings,  after  paying  ten  per  cent  dividends  for  many 
years.  The  friends  of  the  company  claimed  that,  with  a 
capitalization  of  only  $50,000,000  and  with  a  surplus  of  $47,- 
000,000,  the  company  really  had  no  liabilities,  and  was  at 
all  times  in  a  position  to  call  in  its  bonds  and  stock.  The 
Baltimore  &  Ohio,  at  this  time,  in  the  early  eighties,  was 
considered  to  be  the  strongest  railway  corporation  in  the 
United  States.  If  the  company  had  chosen  to  double  its 
capital  stock  in  order  to  capitalize  a  portion  of  its  surplus, 


METHODS    OF   DISTRIBUTING   SURPLUS     249 

the  transaction  could  not  have  been  attacked  either  on  the 
ground  of  expediency  or  legality. 

Within  ten  years  from  1886,  however,  the  company  was 
dragged  into  bankruptcy.  It  embarked  in  a  policy  of  aggres- 
sion directed  against  the  Pennsylvania  Railroad  and  the  New 
York  Central,  and  it  incurred  heavy  liabilities  for  new  con- 
struction. The  result  was  that,  while  its  fixed  charges  in- 
creased, its  earnings  were  reduced.  In  1883  and  1884,  the 
Baltimore  &  Ohio  had  earned  a  surplus  over  dividends  of 
$2,000,000.  By  1887  this  had  fallen  to  less  than  $40,000,  a 
large  floating  debt  had  been  accumulated,  and  in  1888  a 
thorough  reorganization  was  arranged  for.  In  connection 
with  this  reorganization,  the  surplus  appearing  on  the  books 
of  the  company,  and  which  was  discovered  to  have  been  in- 
vested in  forms  which  were  no  longer  productive,  was  scaled 
down  from  $48,000,000  to  $23,000,000.  In  reality,  the  sur- 
plus which  the  Baltimore  &  Ohio  had  been  carrying  for  many 
years  was  no  more  than  an  accumulation  in  a  depreciation 
account.  The  money  had  been  spent  upon  the  property,  and 
the  property  had,  notwithstanding,  been  allowed  to  fall  below 
the  standard  of  efficiency  maintained  by  its  rivals,  the  Penn- 
sylvania Railroad  and  the  New  York  Central.  Within  a  few 
years  after  this  reorganization,  in  1896,  the  company  went 
into  the  hands  of  a  receiver.  Its  equipment  was  found  to  be 
in  a  wretched  condition,  the  entire  property  needed  recon- 
struction; the  paper  surplus  had  disappeared. 

The  same  criticism  can  be  directed  against  the  directors 
of  the  Alton.  The  surplus  which  they  capitalized  and  dis- 
tributed was  fictitious.  This  company  connects  Chicago,  St. 
Louis,  and  Kansas  City.  In  1898  it  had  only  a  small  capi- 
talization, as  indicated  in  the  quotations  from  President 
Blackstone's  reports.  Its  earnings  for  many  years  had  been 
stationary,  but  it  was  regarded  as  a  strong  property.  A 
syndicate,  represented  by  Mr.  Harriman,  Mr.  James  Still- 
man,  and  Mr.  Mortimer  Schiff,  set  out  to  acquire  the  prop- 
erty for  the  purpose  of  recapitalizing  it  and  making  a  quick 
profit.     The  method  which  they  followed  was  to  organize  a 


250  COEPOKATION   FINANCE 

competing  company  and  to  start  the  construction  of  a  line 
paralleling  the  Alton  from  St.  Louis  to  Chicago. 

The  Alton  stockholders  were  greatly  disturbed  by  these 
developments.  The  net  earnings  of  the  Alton  were  not  in- 
creasing. The  stockholders  could  gain  no  comfort  from  the 
large  paper  surplus  which  the  books  of  the  company  showed, 
because  the  standard  of  efficiency  of  their  property  was  not 
up  to  that  of  its  competitors.  The  standards  of  construction 
were  those  of  fifteen  years  before.  The  track  was  laid  with 
steel  rails,  but  those  were  only  seventy  pounds  to  the  yard. 
The  bridges  were  in  good  condition,  but  were  too  light  for 
heavy  engines.  The  capacity  of  the  sidings  and  second  tracks 
was  inadequate  to  handle  large  increase  in  traffic.  A  cir- 
cular sent  out  by  a  majority  of  the  directors  urging  the  sale 
of  the  stock  to  the  syndicate  at  $175  a  share  contains  the 
following  statement:  "The  Chicago  &  Alton  Railroad  is 
without  connections,  either  east  or  west,  under  its  corporate 
control.  At  important  points  competition  already  existing 
and  threatened,  with  the  general  tendency  to  reduced  rates 
of  transportation  and  to  increased  rates  of  taxation,  it  be- 
comes more  and  more  difficult  for  the  road  to  continue  the 
earnings  of  the  past."  It  is  evident  that  the  directors  had  no 
confidence  that  the  surplus  accumulated  out  of  earnings 
would  be  of  any  great  service  to  the  company  in  meeting  com- 
petition. 

The  condition  of  the  Alton  was  far  below  that  of  its  com- 
petitors. This  is  proven  by  another  quotation  from  the  state- 
ment of  Mr.  Cravath  explaining  why  the  company  failed  to 
pay  a  dividend  on  the  $20,000,000  of  common  stock,  an  issue 
whj'.h  was  made  against  an  anticipated  increase  of  earnings : 
"  The  failure  of  the  Chicago  &  Alton  Company  to  make  the 
expected  earnings  for  the  common  stock  is  due  mainly  to  two 
causes:  first,  it  took  over  $19,000,000  to  modernize  and  fully 
equip  the  property,  instead  of  about  $6,000,000,  as  had  been 
originally  estimated ;  and,  second,  while  the  new  management 
succeeded  in  promptly  increasing  the  gross  revenue  of  the 
company,  the  increase  in  net  earnings  was  very  slight,  be- 


METHODS    OF   DISTKIBUTING   SUKPLUS     251 

cause  of  unexpected  reductions  in  rates,  which,  in  the  case  of 
freight  rates,  seem  to  have  averaged  about  thirty  per  cent." 

Here  is  a  frank  admission  by  counsel  for  the  syndicate 
which  conducted  the  reorganization  of  the  Alton,  that  the 
company  had  not  maintained  a  sufficient  depreciation  ac- 
count, that  its  property  had  not  been  kept  up  to  standard, 
and  that  it  was  necessary  to  borrow  large  sums  of  money  to 
reconstruct  it.  Under  the  circumstances,  the  payment  of 
this  special  dividend  was  wholly  unwarranted,  since  it  repre- 
sented the  capitalization  of  a  surplus,  which,  if  proper  depre- 
ciation had  been  made,  would  have  figured  rather  as  a  deficit. 

We  may  conclude,  therefore,  upon  this  point,  that  great 
caution  should  be  exercised  in  the  recapitalization  of  a  com- 
pany for  the  purpose  of  distributing  a  surgjus  to  stockhold- 
ers. While  such  a  distribution  may  not  be  prohibited  by  the 
laws  of  the  state  incorporating  the  company,  and  while  it 
may  be  justified  as  a  deferred  payment  of  profits,  unless  the 
surplus  has  been  correctly  calculated  by  deducting  the  proper 
maintenance  and  depreciation  charges,  the  company  is  very 
likely  to  find  itself  ^  in  the  position  of  the  Baltimore  &  Ohio, 
with  a  large  paper  surplus  and  a  receiver  in  charge  of  the 
property. 

The  propriety  of  distributing  a  surplus  by  a  process  of 
capitalization  may  be  also  considered  in  comparison  with  the 
method  which  is  followed  by  most  corporations,  and  which 
has  already  been  indicated,  of  investing  profits  in  the  busi- 
ness, increasing  the  earnings  as  a  result  of  this  investment 
of  profits,  and  eventually  adding  to  the  dividend  rate.  If 
the  stockholders  are  content  to  wait,  and  if  the  surplus  earn- 
ings of  the  company  have  been  wisely  invested,  they  will  in 
time  receive  the  benefit  of  these  dividends  in  the  form  of  a 
larger  return  on  their  investment  and  a  higher  value  of  their 
stock.  This  method  is  far  more  conservative  than  that  which 
was  followed  in  the  case  of  the  Alton.  In  reality  it  makes 
little  difference  to  the  stockholder  who  holds  the  hundred 
shares  of  stock  on  which  $5  a  share  is  being  paid,  whether 
he  receives  from  the  company  twenty  shares  of  stock  as  a 


252  COEPOKATION  FINANCE 

special  dividend  to  capitalize  surplus,  or  whether  he  receives 
out  of  the  earnings  of  the  company  an  extra  dollar  of  divi- 
dend. In  the  first  case,  since  the  regular  dividend  is  pre- 
sumably to  be  maintained^  he  receives  the  existing  rate  of 
five  per  cent  on  120  shares  of  stock,  or  $600  a  year.  In  the 
second  case  he  receives  the  same  amount  expressed  as  a 
six  per  cent  dividend  on  100  shares  of  stock,  or  $600  per 
year.  In  case  he  wishes  to  sell  his  new  stock,  he  could  prob- 
ably take  a  larger  profit  in  the  appreciation  of  the  market 
value  of  his  holdings;  the  value  of  twenty  shares' of  stock 
paying  five  per  cent  dividends  would  be  greater  than  the  ad- 
dition to  the  value  of  his  100  shares  by  the  increase  of  one 
per  cent  in  the  dividend  rate.  This  consideration  is,  how- 
ever, insufficient  to  outweigh  the  argument  that  the  most 
conservative  policy,  in  the  majority  of  cases,  is  the  wisest. 
The  most  conservative  policy  for  a  corporation,  in  distribut- 
ing its  surplus  to  stockholders,  is  to  increase  dividends  when- 
ever earnings  warrant  rather  than  to  issue  stocks  or  bonds  for 
which  no  value  is  received.  These  may  represent  merely  the 
capitalization  of  a  surplus  which  is  unlikely  to  be  offset  by 
assets  producing  a  sufficient  revenue  to  warrant  the  increase 
in  capitalization. 


CHAPTER   XIX 

THE  PROVISION  OF  NEW  CAPITAL 

Every  prosperous  corporation  is  continually  adding  to  its 
plant  in  order  to  increase  its  profits.  The  extent  of  these 
additions  to  plant  may  be  seen  by  comparison  of  the  item 
"  cost  of  plant "  in  the  case  of  a  number  of  our  leading  cor- 
porations over  a  period  of  years.  Such  a  comparison  appears 
in  the  following  table : 


1900 

1907 

Pennsylvania  Railroad 

Baltimore  &  Ohio 

$125,789,918.95 

125,969,036.90 

218,302,680.50 

130,520,818.00 

3,400,002.00 

1,232,585,197.10 
41,142,251.00 

$291,061,204.00 

165,066,928.00 

259,148,727.00 

373,951,998.00 

9,000,000.00 

1,435,540,068.00 
53,592,166.00 

Chicago,  Milwaukee  &  St.  Paul . 

Union  Pacific 

General  Electric 

United  States  Steel  Corporation 
1901 

Republic  Iron  &  Steel  Co 

Taking  all  the  railroads  of  the  United  States,  we  find 
that  their  cost  of  road  and  equipment  increased  from  1900 
to  1907,  inclusive,  $2,879,800,000.  Every  prosperous  corpo- 
ration, whether  the  fact  appears  in  its  balance  sheet  or  not, 
has  followed  a  similar  line  of  development.  Its  productive 
assets  are  steadily  growing,  more  rapidly  during  some  periods 
than  at  others,  but  increasing  to  some  extent  in  eyery  year . 
of  its  existence.  '  '  * 

The  distinction  between  an  expenditure  which  should  be 
charged   to   operating   expense,   and   an   expenditure   which 
should  be  charged  to  capital  and  appear  as  an  increase  in 
—  253 


254  COKPORATION   FINANCE 

some  asset  account,  is  found  in  the  fact  that  an  expenditure, 
to  be  properly  capitalized,  should  result  in  a  certain  and  ap- 
proximately definite  increase  in  the  profits  of  the  company, 
an  increase  which  is  more  than  sufficient  to  pay  interest  or 
dividends,  at  the  rate  paid  by  the  company  on  its  existing 
liabilities,  on  the  amount  necessary  to  make  the  improve- 
ment. From  the  class  of  expenditures'  which  can  be  prop- 
erly capitalized,  on  the  basis  of  this  definition,  the  so-called 
betterment  expenditures  should  be  excluded.  While  better- 
ments may  result  in  decreasing  the  operating  expenses  of  a 
company,  the  amount  of  the  increase  is  usually  uncertain, 
and,  as  has  already  been  shown,  the  necessities  of  competi- 
tion and  the  demands  of  the  public  and  of  the  consumer 
for  improved  service  and  better  products,  make  it  prudent 
and  even  necessary  for  a  well-managed  company  to  charge 
into  their  current  operating  expenses  large  amounts  repre- 
senting the  cost  of  raising  their  property  to  higher  standards. 
An  expenditure  is  capitalized  when  it  is  added  to  some  asset 
account,  appearing  also  on  the  liability  side  of  the  balance 
sheet  either  as  an  addition  to  stocks,  bonds,  unfunded  debt, 
surplus,  or  some  one  of  the  reserves  which  may  be  carried. 
Capitalized  expenditures  should  result  in  positive  additions  to 
the  business  of  the  company.  The  construction,  for  example, 
of  a  new  mill,  or  the  purchase  of  railway  equipment,  or  the 
construction  of  lines  into  new  territory,  are  examples  of  ex- 
penditures which  could  be  properly  capitalized.  On  the  other 
hand,  under  ordinary  conditions,  such  expenditures  as  the  sub- 
stitution of  heavy  rail  for  light  rail,  the  rebuilding  of  locomo- 
tives, the  elevation  of  tracks  to  increase  the  speed  and  safety 
of  passenger  traffic,  the  improvement  of  passenger  stations, 
the  substitution  for  out-of-date  machine  tools  of  new  shop 
equipment,  are  properly  betterments,  and  their  cost  should 
not  appear  in  any  asset  account.  ^ 

The  influence  which  is  most  effective  in  forcing  a  cor- 
poration into  the  policy  of  expanding  its  plant  is  the  neces- 
sity of  guarding  against  the  encroachment  of  competitors  by 
occupying  the    territory    harboring   the   business    on   which 


THE   PKOVISION   OF   NEW   CAPITAL         255 

these  competitors  would  thrive.  If  the  demand  for  its  prod- 
ucts or  services  increases,  the  corporation  must  enlarge  its 
facilities  to  supply  the  demand;  if  it  does  not,  and  competi- 
tors are  permitted  to  occupy  the  new  territory  without  a 
struggle,  there  is  danger  that  they  may  follow  up  this  con- 
quest by  an  approach  to  closer  quarters.  A  forcible  illustra- 
tion of  the  reasons  for  providing  additional  capital  funds  is 
given  in  a  circular  letter  of  the  president  of  the  Central 
Union  (Bell)  Telephone  Company  to  the  stockholders  in 
1901,  at  the  time  when  the  Bell  company  was  embarking  on 
its  policy  of  expansion : 

"After  two  months'  investigation  I  find  it  imperatively 
necessary  that  at  least  $3,000,000  be  provided  without  delay. 
The  people  of  the  states  of  Illinois,  Indiana,  Ohio,  and  Iowa 
want  telephone  service.  Will  you  supply  it,  or  must  some 
one  else?  Are  you  doing  it  with  fewer  than  70,000  stations? 
N"o.  When  you  have  300,000  exchange  stations,  then  you 
have  a  good  start,  not  before.  When  you  have  150,000  ex- 
change stations,  at  proper  rates,  you  will  have  a  plant  upon 
which  you  can  earn  something  with  which  to  build  up  the 
second  150,000.  With  your  present  70,000  stations,  you  can- 
not build  up  anything  except  opposition.  You  are  not  sat- 
isfying the  public,  because  your  system  does  not  reach  far 
enough.  There  are  scores  of  villages  and  small  towns,  taken 
as  a  whole,  that  should  have  50,000  telephones,  and  in  which 
the  company  has  not  one  single  instrument.  What  you  want 
done  must  be  done  now.  Later  on,  and  a  very  little  later  at 
that,  will  be  too  late." 

A  recent  illustration  of  the  truth  of  the  observations  con- 
tained in  this  cii*cular  came  under  the  writer's  observation 
in  Hammonton,  N".  J.,  a  town  of  about  4,000  people.  The 
Bell  Telephone  Company  had  exclusive  possession  of  the  field ; 
there  were  only  about  twenty-five  stations  in  the  town;  the 
instruments  were  antiquated,  the  service  wretched,  the  rates 
high.     Since  the  Bell  company  showed  no  disposition  to  im- 


256  COKPOKATION  FINANCE 

prove  matters,  the  citizens  of  the  town  organized  a  company, 
raised  $20,000,  and  installed  an  exchange,  which  now  serves 
300  subscribers  and  which  furnishes  a  considerable  amount 
of  long-distance  business  to  the  competitor  of  the  Bell  com- 
pany. The  Bell  company  could  easily  have  had  these  300  sub- 
scribers if  they  had  shown  proper  enterprise.  As  it  is,  the 
business  of  this  community  is  practically  lost  to  them. 

Closely  allied  to  considerations  of  necessity  are  the  con- 
siderations of  financial  advantage  which  are  offered  to  every 
prosperous  corporation  in  the  enlargement  of  its  plant  or  the 
extension  of  its  control  over  other  corporations.  These  ad- 
vantages are  as  follows:  First,  the  restriction  or  regulation 
of  competition,  by  which  rates  or  prices  may  be  increased; 
second,  the  enlargement  and  improvement  of  the  plant  to 
handle  increasing  business  at  a  lower  cost;  third,  the  ex- 
penditure of  money  to  develop  the  territory  and  to  enlarge 
the  sales  of  the  company.  The  policy  of  the  Pennsylvania 
Eailroad  since  1900  furnishes  illustrations  of  the  realization 
of  each  of  these  advantages  by  a  progressive  corporation.  In 
1900  the  capital  liabilities  of  the  Pennsylvania  Eailroad  in- 
creased $72,838,475 ;  in  1901,  $31,379,637;  in  1902,  $52,829,- 
284;  in  1903,  $125,973,000— a  total  increase  of  $283,020,396 
in  the  assets  of  the  company  within  four  years.  This  was 
followed  in  1904, 1905,  and  1906  by  further  increases  of  $136,- 
217,897.  The  money  which  the  Pennsylvania  Eailroad  re- 
ceived and  spent  from  1900  to  1906  was  sufficient  to  build  and 
fully  equip,  at  $60,000  per  mile,  a  trunk  line  railway  of  6,987 
miles  in  extent.  It  is  an  amount  far  greater  than  the  capital 
liabilities  of  most  of  the  larger  railroad  companies  in  the 
United  States. 

When  this  increase  of  the  Pennsylvania's  capital  is  ana- 
lyzed, and  when  the  purposes  to  which  the  funds  were  applied 
are  understood,  this  large  increase  of  capital  is  seen  to  have 
been  not  merely  warranted  by  the  earning  power  of  the  com- 
pany's property,  but  imperatively  demanded  by  the  competi- 
tive situation  in  the  trunk  line  territory  and  by  the  growth 
of  the  traffic  which  was  pressing  for  immediate  shipment. 


THE   PROVISION   OF   NEW   CAPITAL        257 

The  purposes  for  which  the  funds  obtained  by  this  increase 
of  capital  were  devoted  were  three:  (1)  the  purchase  of  a 
dominant  interest  in  the  stocks  of  the  Baltimore  &  Ohio,  the 
Norfolk  &  Western,  the  Chesapeake  &  Ohio,  the  Western 
New  York  &  Pennsylvania,  and  the  Long  Island  railroads; 
(2)  the  improvement  and  enlargement  of  the  physical  prop- 
erty of  the  Pennsylvania  Railroad  Company;  (3)  the  building 
of  extensive  terminal  improvements  in  New  York  City,  in- 
volving the  construction  of  a  tunnel  passing  under  Manhattan 
Island  and  connecting  New  Jersey  with  Long  Island,  and  a 
large  passenger  station  on  Manhattan  Island. 

The  inauguration  of  the  policy  of  purchasing  securities 
of  competing  lines  was  foreshadowed  in  the  report  of  1899 : 

"  While  the  growth  of  your  traffic  and  its  successful  move- 
ment are  subjects  for  congratulation,  your  board  has  to 
report  a  further  reduction  in  the  average  ton  mile  rate. 
For  years,  the  compensation  of  the  trunk  lines  for  moving 
freight  traffic  has  steadily  decreased.  As  may  be  supposed, 
railway  managers  have  not  seen  this  reduction  without  seri- 
ous concern,  or  without  making  strenuous  efforts  to  check  the 
downward  movement.  These  efforts  have  met  with  but  little 
success.  Had  the  railway  companies  not  been  able  to  meet 
the  diminution  in  the  ton  mile  rate  by  a  corresponding  re- 
duction in  expenses,  disastrous  results  must  have  followed. 
But  there  is  a  limit,  and  it  cannot  be  far  off,  to  the  possible 
lessening  of  the  cost  of  movement.  The  only  alternative  is 
to  arrest  the  reduction  in  revenue,  which  has  been  largely 
brought  about  by  apparently  uncontrollable  conflicts  between 
the  railway  companies,  and  between  rival  communities.  The 
problems  involved  are  not  incapable  of  solution,  and  it  is 
believed  that  by  earnest  and  united  effort  the  difficulties  in 
the  way  may  be  met  and  overcome.  With  this  end  in  view, 
it  has  seemed  wise  to  your  board  to  acquire  an  interest  in 
some  of  the  railways  reaching  the  seaboard  and  to  unite 
with  the  other  shareholders  who  control  these  properties  in 
supporting  a  conservative  policy.     This  will,  it  is  hoped, 


258  COEPORATION   FINANCE 

result  in  securing  reasonable  and  stable  rates  and  do  away 
with  unjust  discrimination." 

These  observations  of  President  Cassatt  referred  to  the 
inauguration  of  a  program  of  purchasing  stock  interests  in 
competing  lines  which  was  carried  on  until  the  Pennsylvania 
had  acquired  a  dominant,  although  not  a  majority,  stock  inter- 
est in  its  three  southern  competitors  in  the  soft  coal  traffic,  and 
was  able  to  influence  their  policy.  Beneficial  results  were 
immediately  apparent.  Soft  coal  rates,  which  had  been  utterly 
demoralized,  and  in  which  the  grossest  and  most  burdensome 
discriminations  had  long  existed,  were  immediately  advanced 
to  a  profitable  basis,  and  imposed  upon  all  shippers  alike. 
The  most  important  item  of  the  Pennsylvania  traffic,  in 
which  there  had  hitherto  been  small  profit,  was  turned  into 
a  valuable  source  of  revenue.  Although  in  the  succeeding 
four  years  the  freight  traffic  of  the  Pennsylvania  increased 
only  9,625,000  tons,  or  9.6  per  cent,  the  gross  earnings  from 
freight  traffic  increased  from  $51,395,733  to  $73,899,939,  a 
conclusive  proof  of  the  beneficial  results  of  the  application 
of  the  principle  of  community  of  interest  to  the  solution  of 
the  problem  of  soft  coal  rates  with  which  the  Pennsylvainia  was 
confronted  in  1899.  The  profitableness  of  the  freight  traffic 
of  the  Pennsylvania  during  this  period  increased  nearly  five 
times  as  rapidly  as  the  amount  of  the  tonnage  moved.  These 
investments  in  the  stocks  of  the  bituminous  coal  carrier^  were 
profitable,  not  because  of  dividends  received  by  the  corpora- 
tion which  did  not  quite  equal  the  interest  paid  on  the  pur- 
chase money  obligations,  but  because  of  the  higher  rates  on 
coal  which  these  purchases,  representing  control  of  compet- 
ing lines,  made  possible,  and  which  amounted  to  consider- 
ably more  than  the  interest  on  the  bonds.  Since  the  passage 
of  the  Hepburn  Law  in  1906,  the  Pennsylvania  Railroad 
Company  has  disposed  of  a  large  part  of  these  securities  and 
has  definitely  abandoned  the  attempt  to  influence  its  com- 
petitors by  a  large  representation  on  their  directorates.  The 
necessity  for  these  holdings  no  longer  existed  owing  to  the 


THE   PKOVISION   OF   NEW   CAPITAL        259 

disappearance  of  the  distrust  and  uneasiness  which  formerly 
characterized  the  relations  of  the  trunk  line  executives. 
Furthermore,  the  Interstate  Commerce  law  has  now  been  so 
strengthened  that  secret  rate  cutting  is  a  thing  of  the  past. 
It  should  be  remarked  that  the  Pennsylvania  Eailroad,  in 
addition  to  the  dividends  which  it  received  on  the  stocks  of 
the  soft  coal  carriers,  made  a  profit  of  over  thirteen  million 
dollars  on  such  of  them  as  it  sold.^ 

The  second  object  of  the  Pennsylvania's  expansion  of  its 
capital  during  this  period  was  the  improvement  of  its  physical 
property.  The  equivalent  of  a  double  track  railroad  has  been 
built  from  New  York  to  Pittsburg  and  equipped  with  rolling 
stock  and  yard  and  terminal  facilities.  As  a  result  of  this  ex- 
penditure the  company  now  has  a  four-track  road  between 
Pittsburg  and  Philadelphia,  and  six  tracks  between  Harris- 
burg  and  New  York.  By  making  large  expenditures  on 
equipment  the  company  has  also  increased  the  tractive  power 
of  its  locomotives  and  the  capacity  of  its  freight  cars.  Large 
sums  have  also  been  spent  upon  supplementary  improvements, 
such  as  stations,  expansion  of  yards  and  track  elevation,  all 
of  which  increased  the  capacity  of  the  road. 

In  the  face  of  enormous  expenditures,  and  in  spite  of 
the  notable  gains  in  operating  efficiency  which  they  brought 
about,  the  facilities  of  the  Pennsylvania  proved  inadequate 
to  the  demands  of  this  period.  As  President  Cassatt  re- 
marked in  his  report  for  1902 : 

"The  remarkable  development  of  business,  particularly 
in  the  sections  served  by  your  lines,  created  a  demand  for 
transportation  which  could  not  be  supplied.  For,  although 
the  traffic  carried  over  the  roads  comprising  your  system 
east  and  west  of  Pittsburg  aggregated  nearly  270,000,000 
tons,  being  an  increase  of  26,000,000  tons,  or  more  than  ten 
per  cent  over  the  previous  year,  the  necessities  of  the  indus- 
tries dependent  upon  your  lines  demanded  a  much  larger 

» In  1909  a  large  interest  in  the  Norfolk  &  Western  was  acquired  by 
the  Pennsylvania,  whose  control  of  the  company  is  again  effective. 


260  CORPOKATION  FINANCE 

movement.  The  inability  to  accommodate  these  industries 
was  due  mainly  to  lack  of  track  and  yard  facilities.  It  has 
been  the  policy  of  your  management  for  years  past  to  con- 
tinually increase  these  facilities  so  as  to  keep  them  up  to 
the  demands  of  the  traffic ;  but  although  heavier  expenditures 
have  been  made  for  this  purpose  since  the  beginning  of  the 
present  period  of  business  activity  than  ever  before  in  the 
same  time,  the  exceptional  growth  of  the  tonnage  has  out- 
stripped the  facilities  that  it  was  practicable  to  create." 

Primarily  as  a  result  of  these  large  expenditures,  result- 
ing in  an  increase  of  capacity  of  its  plant,  the  tonnage  carried 
by  the  Pennsylvania  increased  from  133,433,845  tons  in  1902 
to  223,810,040  tons  in  1907,  an  increase  of  90,376,195  tons, 
which  represented  the  total  tonnage  of  the  entire  system 
twenty-one  years  before.  Without  this  expenditure,  this  traf- 
fic could  not  have  been  handled,  and  the  increase  in  operating 
earnings  from  1902  to  1907,  which  amounted  to  $32,051,552, 
could  not  have  been  realized. 

The  final  field  of  the  Pennsylvania  Railroad's  expansion 
policy  was  the  New  York  terminal  project.  This  will  re- 
quire, when  completed,  an  expenditure  of  about  $150,000,000. 
The  traffic  situation  in  New  York  is  peculiar.  The  total 
area  of  Manhattan  Island,  excluding  Central  Park,  is  20.6 
square  miles.  Upon  this  small  spot  of  ground  is  concentrated 
a  population  exceeding  2,000,000.  In  the  census  year  of  1900, 
New  York  had  a  population  of  89,805  to  the  square  mile,  as 
compared  with  9,951  for  Philadelphia,  13,044  for  Boston,  and 
8,939  for  Chicago.  These  figures  indicate  the  extreme  con- 
gestion of  population  which  is  due  to  the  fact  that  the  city 
is  located  upon  an  island.  If  communication  with  the  sur- 
rounding country  could  be  established,  the  population  would 
spread  into  the  suburbs,  a  movement  similar  to  that  which 
has  followed  the  growth  of  other  large  cities.  To  the  resi- 
dent of  New  York,  however,  immigration  to  the  suburbs  is 
denied.  East,  on  Long  Island,  are  large  territories,  almost 
unoccupied,  offering  desirable  places  of  residence,  but  from 


THE   PKOVISION   OF   NEW   CAPITAL        261 

these  opportunities  of  suburban  residence  the  resident  of  Man- 
hattan is  cut  off  by  the  barrier  of  the  East  River.  If  easy 
communication  with  Long  Island  were  to  be  established,  there 
could  be  no  doubt  that  a  vast  exodus  of  population  from  Man- 
hattan would  result.  As  the  matter  stood,  however,  the  large 
number  of  hardy  commuters  who  were  willing  to  run  chances 
of  missed  boats  and  trains  is  a  small  fraction  of  the  number 
who  will  move  into  the  suburbs  when  these  obstacles  are 
eliminated. 

This  task  of  eliminating  the  river  problem  from  the 
transportation  situation  in  New  York  has  been  left  for  the 
Pennsylvania  Railroad  to  undertake.  The  Interborough  Com- 
pany and  the  Hudson  companies,  which  have  also  carried 
tunnel  projects  to  completion,  followed  the  lead  of  the  Penn- 
sylvania. The  Pennsylvania  Railroad  has  completed  two 
tunnels  between  New  Jersey  and  its  new  terminal  at  Thirty- 
fourth  Street  and  Seventh  Avenue,  and  four  tunnels  from 
this  point  to  its  Long  Island  terminal  at  Long  Island  City. 
These  tunnel  improvements  will  bring  Manhattan  into  imme- 
diate connection  with  the  mainland  and  with  Long  Island,  and 
will  result  in  a  large  migration  from  Manhattan  Island  to 
places  of  more  desirable  residence.  In  Long  Island  particu- 
larly, the  largest  and  most  desirable  residential  territory  which 
is  tributary  to  any  city  in  the  United  States,  will  be  opened 
by  these  improvements,  which  will  practically  insure,  within 
the  next  decade,  an  immense  population  throughout  the  east- 
ern part  of  the  island. 

The  advantages  of  these  improvements  to  the  Pennsylvania 
lies  in  the  fact  that  this  corporation  owns  a  majority  of  the 
stock  of  the  Long  Island  Railroad  Company  which  controls 
the  Long  Island  territory.  It  is  true  that  the  connection 
with  the  mainland  will  increase  the  share  of  the  Pennsyl- 
vania in  the  competitive  passenger  business  to  the  south  and 
west,  making  the  Pennsylvania  route  quite  as  convenient  as 
the  New  York  Central  from  its  Forty-second  Street  terminal. 
It  will  also  develop  the  passenger  business  between  Washington 
and  New  York,  already  largely  controlled  by  the  Pennsyl- 
18 


262  CORPOKATION  FINANCE 

vania,  and  will  throw  to  the  Pennsylvania  lines  a  large  part 
of  the  through  passenger  business  which  originates  in  Brook- 
lyn and  along  the  lines  of  the  Long  Island  Railroad. 

These  gains  are,  however,  unimportant  compared  with  the 
opportunities  offered  by  the  development  of  Long  Island 
territory.  In  Long  Island,  the  terminal  improvements  will 
build  up  a  large  and  permanent  suburban  traffic  for  the 
Long  Island  Railroad.  With  the  completion  of  the  tunnel 
project,  the  Long  Island  Railroad  Company  will  be  able  to 
carry  passengers  from  Thirty-fourth  Street  thirty  miles  into 
the  country  in  less  time  than  the  Manhattan  Elevated  Railroad 
now  requires  to  take  them  from  the  Battery  to  125th  Street, 
offering  them,  moreover,  not  merely  a  quicker  passage,  but  a 
more  comfortable  journey. 

Of  far  greater  importance,  however,  than  the  increase  of 
passenger  business  which  will  follow  the  completion  of  the 
tunnel  project,  is  the  growth  in  the  freight  traffic.  The 
receipts  from  freight  traffic  on  the  Long  Island  have  been 
far  below  the  returns  from  passenger  traffic.  This  company 
has  been  mainly  dependent  upon  summer  resort  travel.  It 
usually  fails  to  earn  its  interest  charges  during  the  winter 
months.  On  the  New  Haven  &  Hartford,  on  the  other  hand, 
the  returns  from  freight  and  passenger  traffic  are  about 
equal.  The  reason  for  this  discrepancy  in  the  division  of 
receipts  is  that  Long  Island,  up  to  the  present  time,  has  been 
practically  vacant  territory.  Only  in  the  summer  is  its 
population  large.  In  1900  its  entire  population,  outside  of 
Brooklyn,  was  only  286,000.  With  Long  Island  brought  into 
communication  with  the  mainland,  the  shifting  of  popula- 
tion, it  is  expected,  will  build  up  a  large  city  in  the  eastern 
part  of  the  island.  This  population  will  not  only  demand 
a  large  amount  of  merchandise  for  direct  consumption,  but 
the  development  of  a  variety  of  manufacturing  interests  will 
follow  its  growth.  All  these  developments  mean,  moreover, 
a  large  amount  of  freight  over  the  Long  Island  Railroad,  and 
will  give  the  Pennsylvania  a  long  haul  for  a  large  amount 
of  traffic. 


THE   PKOVISION   OF   NEW   CAPITAL         263 

New  capital  may  also  be  required  in  the  form  of  cash 
and  cash  assets  as  working  funds  to  handle  an  increased 
amount  of  business.  If  a  company  makes  large  additions  to 
its  plant,  or  if  the  business  of  its  existing  plant  shows  a 
considerable  increase,  in  case  it  does  not  make  correspond- 
ing additions  to  its  working  capital,  it  is  quickly  forced  to 
become  a  heavy  borrower,  and  while  this  position  causes  little 
inconvenience  when  rates  of  interest  are  low  and  money  easily 
obtained,  should  a  financial  stringency  occur,  bankruptcy 
may  be  the  result.  Even  under  ordinary  conditions,  an 
inadequate  working  capital  may  be  the  cause  of  heavy  expense 
to  the  corporation.  The  experience  of  the  Pressed  Steel 
Car  Company  is  in  point.  The  report  of  the  president  for 
the  year  ending  December  31,  1901,  contains  the  following: 

"  Since  the  incorporation  of  the  company  the  profits  have 
aggregated  $4,312,285.  Out  of  these  profits  has  been  paid 
$2,625,000  in  dividends.  The  McKees  Eocks  plant  cost 
$1,581,580,  and  additions  and  improvements  to  original 
plants,  amounting  to  $555,702,  have  been  taken  out  of  the 
initial  working  capital  and  earnings.  From  this  it  will  be 
seen  that  the  actual  cash  working  capital  has  been  somewhat 
encroached  upon,  but  the  plants  and  capacity  have  been  more 
than  doubled,  and  the  monthly  production  increased  from 
$1,000,000  to  upward  of  $2,000,000,  the  full  operation  of 
the  plants. 

"  It  is  necessary  to  carry  between  $4,000,000  and  $5,000,- 
000  worth  of  material  on  hand,  and  for  this  purpose  the 
company  has  been  compelled  to  be  an  extensive  borrower. 
During  the  year  it  was  thought  prudent  to  fund  this  in- 
debtedness. Therefore,  a  mortgage  for  $5,000,000  was  made 
to  secure  five  per  cent  notes  maturing  at  the  rate  of  $500,000 
each  year,  with  the  right  to  anticipate  payment  of  all  or  part. 
These  notes  have  been  disposed  of  on  terms  advantageous 
to  the  company.  By  this  means  the  company  secures  extra 
working  capital,  and  its  interest  charges  are  limited  to  not 
to  exceed  $250,000  the  first  year,  and  $25,000  less  every 


264  CORPORATION  FINANCE 

year  thereafter.  There  was  disbursed  last  year  for  interest 
and  borrowed  money  $215,821,  which  was  charged  off  to 
operating  expenses,  and  we  believe  that  more  than  the  differ- 
ence appearing  between  this  amount  and  $250,000  can  be 
saved  in  extra  discounts  on  materials  purchased." 

The  Pressed  Steel  Car  Company,  in  funding  its  large 
floating  debt,  not  only  made  the  economies  indicated  in  the 
president's  statement,  but  also  removed  a  serious  danger  of 
financial  embarrassment  which  might  have  resulted  from 
failure  to  renew  these  loans.  The  receivership  of  the  West- 
inghouse  Electric  &  Manufacturing  Company,  in  1907,  was 
due,  in  large  part,  to  inadequate  working  capital,  and  to 
the  efforts  of  the  company  to  supply  this  deficiency  by  con- 
tracting heavy  bank  loans,  and  by  piling  up  large  obligations 
to  merchandise  creditors.  Working  capital  is  properly  re- 
garded, not  merely  as  essential  to  the  safety  and  prosperity 
of  a  company,  but  as  perhaps  the  most  profitable  part  of  its 
equipment  for  business.  It  enables  the  company  to  carry 
large  bank  balances  on  the  strength  of  which,  with  the  com- 
pany's good  credit,  heavy  loans  can  be  made  on  occasion,  to 
take  advantage  of  favorable  opportunities  for  the  purchase  of 
materials  and  to  discount  bills,  while,  at  the  same  time,  it 
makes  unnecessary  the  resort  to  the  banks  for  more  than  tem- 
porary and  occasional  accommodation. 

New  capital  may  be  finally  required  for  the  reconstruc- 
tion of  a  plant  where  a  profitable  business  has  been  sacrificed 
because  the  physical  condition  of  the  property  has  been  neg- 
lected. A  case  in  point  is  that  of  the  Kansas  City  Southern 
Railway  Company  when  taken  over  by  the  new  management. 
Here  was  a  road  operating  in  a  territory  rich  in  traffic  possi- 
bilities, and  carrying  a  sufficient  amount  of  traffic  to  pay  its 
interest  charges,  in  spite  of  its  impaired  physical  condition. 
It  was  estimated  that,  to  put  the  property  in  a  suitable  con- 
dition for  handling  present  and  prospective  traffic,  and  to  ex- 
pand the  business  of  the  company  to  its  proper  proportions, 
the  following  expenditures  would  be  necessary: 


THE   PROVISION   OF   NEW   CAPITAL        265 

Repairs  and  improvements  to  track $2,983,856 .  00 

Reinforcements  and  reconstruction  of  bridges 510,000 .  00 

Repairs  and  improvements  to  equipment 540,000.00 

New  tracks 388,000.00 

New  freight  depot  facilities 125,000 .  00 

New  water  stations 65,000 .  00 

New  shop  faciUties 435,000.00 

New  telegraph 34,000.00 

New  fencing 180,000 .  00 

Work  at  Port  Arthur,  Texas 50,000.00 

New  equipment 1,604,749 .  50 

Total $6,915,605.50 

Practically  all  of  these  expenditures,  with  the  exception  of 
the  equipment  purchases,  should  have  been  spread  over  a 
period  of  years,  and  charged  to  operating  expenses,  not  to 
capital.  Over  $5,000,000  of  the  amount  which  was  deemed 
necessary  to  be  spent  on  the  property  represented  deferred 
charges  to  maintenance  and  betterments.  The  company  should 
not,  in  a  narrow  view  of  the  situation,  have  received  any  capi- 
tal for  the  reconstruction  of  its  plant,  but  should  have  de- 
voted its  surplus  income  to  the  purpose.  Under  the  conditions 
confronting  the  management,  however,  there  was  no  surplus 
income.  At  the  same  time,  the  expenditure  of  this  large 
amount  of  money,  no  matter  how  provided,  would  put  the 
company  into  position  to  make  large  earnings.  Said  President 
Edson : 

"  Your  officers  are  convinced  that  with  the  improvements 
and  additions  which  have  been  set  forth,  which  will  require 
two  or  three  years  to  complete,  and  which  will  enable  the  road 
to  handle  expeditiously  and  economically  all  traffic  which  may 
be  offered,  the  gross  earnings  will  show  an  increase  of  from 
twenty  to  twenty-five  per  cent  over  the  gross  earnings  for 
the  year  ending  June  30,  1905,  and  that,  with  the  economies 
which  the  additional  facilities  will  make  possible,  the  ratio 
of  operating  expenses,  including  taxes,  to  gross  earnings,  will 
not  exceed  seventy  per  cent. 

"  Taking  as  a  basis  the  minimum  of  twenty  per  cent  in- 
crease in  gross  earnings,  the  following  results  may  be  con- 
fidently expected  under  existing  commercial  conditions : 


266  COKPOKATION   riNANCE 

Gross  earnings $8,272,387.54 

Operating  expenses  and  taxes 5,790,671 .28 

Net  earnings 2,481,716.26 

Interest  on  bonds  owned 32,501 .  00 

Total  income $2,514,217.26 

Interest  on  bonds ^900,000. 00 

Net  annual  surplus  from  income $1,614,217 .26 

From  which  must  be  paid,  of  course,  the  interest  on  such 
funds  as  may  be  borrowed  for  improvement. 

"  From  this  it  seems  certain  that,  unless  overtaken  by 
some  unforeseen  and  general  commercial  disaster,  the  earn- 
ings capacity  of  the  property  amply  justified  the  capitaliza- 
tion of  the  amount  necessary  for  improvements  and  exten- 
sions." 

The  surplus  for  the  period  to  which  this  report  refers 
was  only  $610,191.80.  This  income  was  in  danger  of  dis- 
appearing, owing  to  the  inability  of  the  company  to  handle 
the  business  offered.  The  expenditure  of  approximately 
$7,000,000  would  show  earnings  of  14.28  per  cent  on  this 
amount.  The  conclusion  that  the  cost  of  rehabilitating  the 
Kansas  City  Southern  ^Railway  Company  should  be  defrayed 
out  of  new  capital  provided  for  the  purpose,  and  charged  to 
the  capital,  instead  of  to  operating  expenses  or  depreciation, 
was  evidently  correct.  Acting  upon  this  advice,  the  stock- 
holders authorized  an  issue  of  $10,000,000  4J  per  cent  second 
mortgage  bonds,  pledging  as  collateral  $5,100,000  negotiable 
gold  notes.  Most  of  the  proceeds  were  spent  in  making  good 
the  omissions  of  the  past  for  the  sake  of  obtaining  the  profits 
of  the  future. 

^AU  deductions  are  not  given. 


CHAPTER    XX 
THE  METHODS  OF  PROVIDING  NEW  CAPITAL 

Our  next  inquiry  is  concerning  the  methods  by  which 
the  necessary  extension  of  plant  and  enlargement  of  corpo- 
rate power  and  influence  is  to  be  accomplished.  A  company 
may  either  raise  money  to  be  invested  in  the  improvement 
and  extension  of  its  plant,  or  it  may  acquire  interests  in 
other  corporations  which  possess  the  necessary  assets.  These 
interests  it  may  acquire  either  directly  by  the  exchange  of 
securiti^,  or  through  the  medium  of  a  holding  company,  or 
by  selling  its  own  securities  to  the  investor,  expending  the 
proceeds  upon  the  securities  desired,  or  by  some  form  of 
lease  of  the  desired  property,  or  by  a  working  agreement  by 
which  the  use  of  the  desired  facilities  is  obtained.  The  first 
plan  is  the  direct  method  of  providing  capital  out  of  in- 
come or  by  the  sale  of  securities ;  and  the  second,  the  indirect 
provision  of  capital  by  various  methods  which  come  under 
the  head  of  consolidation. 

Capital  funds  may  be  directly  provided  for  the  corpora- 
tion by  one  or  more  of  the  following  methods:  (1)  The 
money  required  may  be  appropriated  out  of  profits;  (2) 
stock  may  be  issued;  (3)  the  corporation  may  borrow 
money  either  on  short  time  notes  or  by  the  sale  of  long  term 
bonds.  In  Chapter  XVII  we  have  discussed  the  necessity 
that  a  properly  managed  corporation  should  never  pay  out 
all  its  earnings  to  stockholders.  Conservatism  demands  that 
a  certain  balance  should  be  reserved  and  invested  in  the  busi- 
ness. The  purpose  of  this  reservation  is  to  make  sure  that 
a  dividend  rate,  once  established,  may  be  maintained.    The 

267 


268  CORPOKATION   FINANCE 

investment  of  these  funds  reserved  from  earnings,  if  wisely 
made,  will  increase  the  earnings  of  the  company,  and  should 
appear  as  additions  to  its  assets. 

There  is  much  to  be  said  in  favor  of  a  policy  of  making 
extensions  out  of  profits.  A  growth  which  is  made  out  of 
earnings,  without  increase  of  stock  or  debt,  is  a  natural 
growth;  it  is  made  gradually  and  cautiously,  and  therefore 
safely.  The  histories  of  the  largest  business  concerns  in  the 
country  show  that  even  the  largest  possibilities  can  be 
reached  by  the  investment  of  profits  in  the  extension  of 
plant.  -The  growth  of  the  Carnegie  Steel  Company  from  an 
insignificant  beginning  to  the  gigantic  size  it  had  attained 
when  it  was  taken  over  by  the  United  States  Steel  Corpora- 
tion, is  an  illustration  of  the  possibilities  of  the  investment 
of  profits.  The  growth  of  the  Baldwin  Locomotive  Works, 
and  of  John  Wanamaker's,  and  Marshall  Field's  retail  estab- 
lishments are  familiar  illustrations  of  the  same  fact.  Indeed, 
most  large  business  enterprises  in  this  country  w^iich  are 
still  controlled  by  partnerships  or  private  corporations,  rep- 
resent growth  out  of  profits. 

If  directors  follow  a  conservative  policy  in  the  adminis- 
tration of  the  income  account  of  their  company,  they  will 
make  large  investments  out  of  revenues  in  working  capital, 
plant  and  equipment.  They  will  raise  the  standard  of  the 
property  by  betterment  appropriations,  charged  either  to  ad- 
ditions or,  preferably,  to  maintenance.  They  should  also 
maintain  a  number  of  reserves  for  depreciation  and  renewal 
of  plant,  for  bad  debts,  for  insurance,  for  the  extinguishment 
of  the  loss  sustained  by  the  sale  of  bonds  at  a  discount,  if 
this  loss  is  not  to  be  taken  in  the  year  in  which  it  occurs. 
They  may  be  required  to  set  aside  out  of  their  income  a 
sinking  fund  appropriation,  and  it  may  be  provided  tliat 
the  amount  of  the  sinking  fund  appropriation  can  be  in- 
vested in  the  plant.  Finally,  in  order  to  maintain  an  even 
rate  of  dividends,  the  directors  are  obliged  to  reserve  a  por- 
tion of  each  year's  profits,  which  is  also  put  into  the  business, 
and  which,  in  time,  may  amount  to  a  large  sum.     Shall  the 


METHODS   OF   PROVIDING   NEW   CAPITAL     269 

directors  go  farther  than  these  requirements  of  safety  and 
stability  in  reserving  profits  from  stockholders?  Shall  they 
treat  the  profits  as  their  first  resource  when  in  need  of 
money,  and  comfort  the  stockholders,  as  did  C.  P.  Huntington, 
who,  on  one  occasion,  remarked  to  the  stockholders  of  the 
Pacific  Mail  Steamship  Company,  that  it  made  no  difference 
whether  they  received  their  dividends  in  money  or  in  ships? 
Their  dividends  were  only  deferred. 

It  is  improper  for  the  directors  of  a  public  corporation 
to  pursue  this  policy.  The  company  has  applied  to  the 
investor  to  furnish  funds  for  their  enterprise.  The  money  / 
has  been  contributed  with  the  understanding  that  if  profits 
were  earned  they  would  be  distributed  in  dividends,  so  far 
as  a  distribution  could  safely  be  made.  Beyond  the  main- 
tenance of  proper  reserves,  and  the  investment  of  surplus 
earnings  over  a  conservative  dividend  rate,  the  directors  of  / 
a  public  corporation  cannot,  as  a  rule,  therefore,  with  entire' 
good  faith  to  their  stockholders,  withhold  profits  for  invest- 
ment in  plant.  If  the  business  is  profitable,  and  demands  new 
capital,  the  stockholders  have  the  right  to  demand  that  the 
capitalization  of  the  company  shall  be  increased  in  order  to 
obtain  this  new  capital,  and  that  they  shall  not  be  kept  out  of 
their  dividends  for  an  indefinite  period  in  order  that  a 
so-called  conservative  policy  should  be  pursued.  If  the  com- 
pany needs  new  money,  the  stockholders  are  usually  quite 
willing  to  furnish  it,  in  case  they  have  been  liberally  treated, 
and  fairly  dealt  with. 

There  are  other  objections  to  the  plan  of  exclusive  de- 
pendence on  profits  as  a  source  of  capital  funds.  Profits  are 
very  irregular,  and  it  is  difficult  to  carry  out  a  consistent 
plan  of  improvement  while  depending/solely  upon  the  busi- 
ness to  furnish  the  funds  for  these  improvements.  Further- 
more, the  exigencies  of  the  corporate  situation  sometimes 
demand  that  extensive  schemes  of  improvement  should  be  / 
put  through  within  a  short  time;  for  example,  the  extension 
of  the  Chicago,  Milwaukee  &  St.  Paul  to  the  Pacific  Coast; 
the  construction  of  the  Western  Pacific  from  Salt  Lake  City 


270  COKPOKATION   FINANCE 

to  San  Francisco ;  and  the  New  York  Terminal  improvements 
of  the  Pennsylvania.  Such  gigantic  works  of  construction 
may  in  some  cases  be  provided  out  of  earnings ;  for  example, 
the  new  plant  of  the  United  States  Steel  Corporation  at 
Gary  has  been  built  out  of  profits.  As  a  rule,  however,  earn- 
ings are  not  sufficient  for  extensive  additions. 

Assuming  a  definite  opportunity  for  the  profitable  invest- 
ment of  capital,  it  is  to  the  interest  of  stockholders  that  this 
opportunity  should  be  developed  with  the  greatest  expedition, 
and  that  the  construction  work  should  be  carried  through 
within  the  shortest  possible  time.  If  the  improvement  is 
to  depend  solely  upon  earnings  for  its  completion,  it  may 
be  unduly  prolonged  if  the  earnings  are  not  forthcoming. 
The  profits  of  the  company  over  a  period  of  years  may  be 
much  less  than  if  stock  had  been  sold  or  money  borrowed, 
and  the  work  crowded  through  as  rapidly  as  possible  to  the 
point  of  producing  revenue. 

The  withholding  of  dividends  from  stockholders  at  the 
instance  of  the  majority  control  also  creates  a  bad  im- 
pression, since  it  is  often  alleged,  under  these  circumstances, 
that  the  majority  interests  who  usually  occupy  important  and 
lucrative  positions  in  the  service  of  the  company,  and  who 
are  not  infrequently  in  the  receipt  of  secondary  and  indirect 
emoluments  as  a  result  of  their  positions  are  unfairly  dis- 
criminating against  the  minority  stockholders.  It  may  be 
charged  that  they  are,  in  effect,  pursuing  a  policy  which, 
while  increasing  the  value  of  the  company's  property,  is 
depreciating  the  value  of  the  stock  which  represents  the 
ownership  of  the  corporation  owning  the  property.  Such 
charges  were  forcibly  made  against  the  Southern  Pacific 
management  in  1903  by  Mr.  James  R.  Keene,  who  alleged 
that  the  Southern  Pacific  revenues  were  not  only  being  with- 
held from  the  stockholders  of  that  company,  but  that  they 
were  being  devoted  to  improvements  for  the  benefit  of  the 
Union  Pacific  which  owned  nearly  half  the  stock  of  the 
Southern  Pacific.  Although  the  interests  back  of  this  at- 
tempt to  force  dividends  on  Southern   Pacific  stock  were 


METHODS    OF   PEOVIDING   NEW   CAPITAL     271 

discredited  because  of  their  obvious  connection  with  a  large 
speculative  pool  operating  for  an  advance  in  the  stock,  based 
on  the  alleged  promise  of  a  dividend,  yet  their  contentions 
attracted  wide  attention,  and  brought  out  unfavorable  criticism 
against  the  directors. 

Especial  conservatism  in  the  distribution  of  profits  is 
usually  desirable  during  the  early  stages  of  an  enterprise,  a 
large  part  of  whose  stock,  as  we  have  already  seen,  is  usually 
.issued  against  anticipated  earnings.  With  these  exceptions, 
however,  it  seems  best  that  a  public  corporation  should  not 
rely  mainly  upon  its  earnings  to  obtain  funds  for  extensions 
and  improvements,  but  when  it  has  reached  a  position  of 
assured  strength  and  standing,  it  should  take  advantage 
of  that  position  to  provide  funds  for  the  enlargement  of  its 
plant  by  the  expansion  of  its  capital,  allowing  its  stockholders 
to  share  in  its  profits,  so  far  as  the  distribution  of  these 
profits  is  consistent  with  the  maintenance  of  a  regular  rate 
of  dividend. 

In  view  of  the  rapidly  increasing  number  of  persons  in 
the  United  States  who  rely  upon  dividends  for  a  portion  of 
their  income,  it  will  be  profitable  for  us  to  examine  in  detail 
a  case  in  which  this  policy  of  exclusive  reliance  upon  income 
for  betterments  was  followed  for  a  number  of  years  by  a 
prominent  and  prosperous  railroad,  the  Lehigh  Valley  Rail- 
road Company. 

A  railroad  balance  sheet  presents  a  statement  of  assets 
and  liabilities.  By  comparing  one  balance  sheet  with  another 
the  progress  of  the  road  in  assets  and  earning  power  can  be 
noted.  From  the  movement  of  the  liabilities,  the  sqgji^s 
from  which  funds  were  obtained  can  be  determined/^  series 
of  annual  balance  sheets,  therefore,  contains  the  record  of 
progress  or  deterioration,  the  financial  history  of  the  corpora- 
tion. When  we  examine  the  balance  sheets  of  the  Lehigh 
Valley  from  1898  to  1902,  however,  we  find,  apparently,  that 
for  five  years  the  company  stood  still.  The  principal  items 
of  the  condensed  balance  sheet  for  the  two  years  mentioned 
are  as  follows: 


272 


COKPOKATION   FINANCE 


Assets 

1898 

1902 

Cost  of  road 

$18,639,291.95 
19,018,419.98 
32,949,322.14 

$18,639,291.95 

Cost  of  equipment 

19,018,419.98 
39,300,209 .  80 

Securities  owned 

The  only  change  is  an  increase  of  $6,350,887.66  in  the 
securities  owned,  accounted  for  by  the  acquisition  of  the 
stock  of  the  Lehigh  Valley  Terminal  Company.  As  might 
be  expected,  since  the  valuation  of  assets  did  not  change, 
the  liabilities  remained  unaltered.  The  stock  remained  at 
$40,441,100  and  the  bonds  decreased  from  $45,642,000  to 
$41,900,000.  A  singular  spectacle  was  presented  by  the 
balance  sheets,  a  company  whose  accounts  showed  neither 
growth  nor  decline. 

Turning  from  this  spectacle  of  stagnation  to  examine  the 
income  account  of  the  company,  we  find  a  record  of  growth 
and  prosperity.  Gross  earnings  from  operation  increased 
twenty-five  per  cent  in  five  years.  The  revenue  tonnage  of 
the  road  gained  150  per  cent,  while  the  mileage  remained 
at  about  1,400  miles.  Unless  the  rates  received  suffered 
a  severe  decline,  or  unless  operating  expenses  considerably 
increased,  the  net  income  of  the  company  over  these  five 
years  should  show  a  considerable  increase.  So  far  from 
decreasing,  the  ton  mile  revenue  of  the  Lehigh  Valley  in- 
creased from  0.500  cents  to  0.554  cents.  Furthermore,  not 
merely  did  the  rate  received  for  transporting  each  ton  of 
freight  increase,  but  the  expense  of  moving  the  tonnage  de- 
clined, and  the  total  earnings  per  train  mile  increased  from 
$1.58  in  1898  to  $2.09  in  1902.  From  those  figures  of  earn- 
ings and  expenses,  a  considerable  increase  in  income  available 
for  distribution  to  creditors  and  stockholders  might  be  ex- 
pected. On  the  contrary,  the  gross  income  of  the  Lehigh 
Valley,  which  in  1898,  a  year  of  depression  in  the  traffic  and 
earnings  of  this  section,  was  $6,799,255,  in  1900  was  $3,939,- 


METHODS    OF   PEOVIDING   NEW   CAPITAL     273 

155,  and  in  1901,  when  no  strike  was  in  progress,  was  only 
$6,871,010.  In  short,  the  stockholders,  who  had  received 
no  dividends  since  1893,  were  puzzled  to  understand  why 
their  company  could  be  at  the  same  time  prosperous  and 
unfortunate,  why  it  could  be  making  so  much  money  and  have 
nothing  left  for  dividend  payments  to  its  stockholders,  many 
of  whom  were  sorely  distressed  because  of  the  suspension  of 
dividends. 

Eeserving  for  the  present  the  explanation  of  this  anomaly, 
let  us  compare  the  results  of  1903  with  those  of  1902,  the 
last  year  of  the  administration  which  took  over  the  manage- 
ment of  the  road  in  1897,  and  resigned  it  in  November,  1902. 
On  June  30,  1903,  the  total  income  available  for  distribution 
was  stated  to  be  $8,279,248,  an  increase  of  $3,628,120  over 
the  statement  of  the  preceding  year.  Evidently,  a  sudden 
and  radical  change  in  accounting  methods  had  taken  place 
which,  after  allowing  for  a  million  and  a  quarter  of  dollars 
spent  in  improving  the  property,  showed  net  income  avail- 
able for  dividends  of  two  million  dollars,  or  five  per  cent 
on  the  stock.  More  strictly  interpreted,  the  accounts  of  the 
Lehigh  Valley  for  1903  show  a  surplus  available  for  dis- 
tribution of  8.1  per  cent  on  the  stock,  as  compared  with  a 
deficit  of  more  than  a  million  and  a  quarter  in  1902,  an 
apparent  gain  of  $4,606,485  in  surplus,  although  gross  earn- 
ings increased  only  $2,734,535. 

We  have  here  presented  the  outlines  of  a  noteworthy 
chapter  in  railway  financial  history,  which  raises  a  question 
of  deep  interest  to  railway  investors.  How  far  should  the 
cost  of  improvements  which  increase  the  earnings  of  a  com- 
pany be  taken  out  of  earnings,  and  how  far  should  their 
cost  be  defrayed  by  the  issue  of  new  capital  ?  In  other  words, 
how  far  can  a  corporation,  in  justice  to  its  stockholders,  by 
refusing  to  issue  new  capital,  keep  its  stockholders  out  of 
their  dividends? 

Immediately  after  the  retirement  of  Mr.  Wilbur  from 
the  presidency  and  the  election  of  Mr.  Walter,  the  directors 
of  the  Lehigh  Valley  inaugurated  a  policy  which,  for  con- 


274  COEPOKATION   FINANCE 

servatism  and  extreme  caution  in  the  disbursement  of  profits, 
has  rarely  been  equaled.  In  his  report  for  the  following  year 
the  new  president  stated: 

"The  policy  of  the  present  management  has  been,  and 
perhaps  for  some  time  to  come  must  continue  to  be,  in  the 
line  of  liberal,  and  perhaps  mutual  expenditures  on  both 
roadbed  and  equipment,  in  order  to  adapt  the  property  to 
the  most  economical  operation.  Substantially  all  the  busi- 
ness of  the  company  is  competitive  and  rates  are  steadily 
and  rapidly  declining.  To  derive  any  profit  from  them  the 
railway  must  be  so  improved  in  its  characteristics  as  to  be 
able  to  work  much  more  cheaply  than  before.  The  companies 
with  which  the  Lehigh  Valley  is  in  competition  (New  York 
Central  and  the  Lackawanna)  have  been  adapting  themselves 
to  like  requirements  for  many  years,  but  the  Lehigh  Valley, 
having  done  less  in  these  respects  until  recently,  must  now 
proceed  with  greater  activity." 

In  another  report  Mr.  Walter  explained  the  limited  cap- 
ital resources  of  the  company,  authority  existing  for  the  an- 
nual issue  of  only  $1,000,000  of  bonds.  No  application  was 
made,  however,  for  any  increase  of  this  authority. 

The  plant  of  the  Lehigh  Valley  needed  substantial  im- 
provement. There  was  no  doubt  of  that.  Both  engines  and 
cars  were  light  and  had  to  be  replaced.  Sidings  had  to  be 
lengthened  and  bridges  strengthened  to  admit  of  longer  and 
heavier  trains  being  handled.  The  repair  shops  had  to  be 
concentrated;  the  terminals  enlarged  and  improved,  and 
many  additional  replacements  of  way  and  structure  were  re- 
quired. 

The  reconstruction  of  the  system  required  a  large  amount 
of  money  and  Mr.  Walter  proceeded  to  take  this  out  of 
earnings  and  to  charge  it  to  operating  expense.  For  many 
years  the  operating  ratio  of  the  road  had  been  high,  owing, 
in  part  at  least,  to  inefficient  management  and  inferior  equip- 
ment.    In  1894  the  ratio  was  76.86  per  cent  of  gross  earn- 


METHODS    OF   PEOVIDING   NEW   CAPITAL     275 

ings,  from  which  it  declined  steadily  to  70.16  per  cent  in 
1898.  From  this  point,  the  ratio  advanced  to  80.97,  an 
enormous  and  almost  unprecedented  figure,  in  1902.  More 
significant  than  the  increase  in  the  general  operation  ratio, 
was  the  change  in  the  relations  between  its  component  parts. 
In  1895,  under  the  old  regime,  only  22.56  per  cent  of  the 
total  operating  expense  was  represented  by  maintenance  of 
way  and  structure.  In  1902,  this  proportion  had  increased 
to  40.31  per  cent.  All  this  time  the  efficiency  of  the  system, 
as  represented  in  its  average  train  load,  was  steadily  increas- 
ing from  383.87  tons  in  1898  to  466.83  tons  in  1902,  a 
larger  train  load  than  even  the  New  York  Central  could 
show.  This  increased  efficiency  of  operation  was  the  result 
of  the  reconstruction  of  the  property.  The  entire  cost  of  these 
replacements  and  repairs  was  charged  to  operating  expenses. 
From  1898  to  1902,  if  we  allow  sixty-five  per  cent  as  the  nor- 
mal operating  ratio,  the  Lehigh  Valley,  under  Mr.  Walter's 
management,  spent  almost  thirteen  million  dollars,  which, 
under  different  circumstances,  would  have  been  available  for 
interest  and  dividends. 

We  can  now  answer  the  question  which  was  raised  con- 
cerning the  legitimacy  of  the  policy  pursued  by  the  former 
management  of  the  Lehigh  Valley.  Looking  at  the  matter 
from  the  standpoint  of  the  physical  condition  of  the  property, 
a  very  plausible  defense  can  be  made  for  charging  the  cost 
of  its  rehabilitation  to  operating  expense.  If  all  expenses 
which  result  in  raising  a  railroad  toward  the  standard  set 
by  its  competitors  are  to  be  classed  as  operating  expenses, 
no  criticism  can  be  made.  The  physical  condition  of  the 
New  York  Central  was  apparently  taken  as  the  goal  of  the 
Lehigh  Valley's  ambition.  Only  when  the  Lehigh  Valley 
had  been  rebuilt  on  the  Central's  model,  were  the  stock- 
holders to  get  anything.  Looked  at  as  a  problem  in  com- 
parative operating  efficiency,  Mr.  Walter's  method  of  solution 
can  be  approved,  the  more  so  because  he  succeeded  in  his 
attempt. 

When  we  consider  the  matter  from  the  standpoint  of  the 


276  COKPOKATION  FINANCE 

Lehigh  Valley  stockholders,  however,  the  severe  criticism 
to  which  the  management  was  subjected  is  seen  to  be  not 
without  some  measure  of  justification.  There  can  be  no 
question  that  if  the  difficulties  in  the  way  of  issuing  new 
capital  had  been  got  over,  and  these  difficulties  were  by  no 
means  insuperable,  the  company  could  have  borrowed  far 
more  than  the  amount  which  was  reserved  from  earnings,  and 
could  have  effected  the  necessary  improvements  within  a 
short  time,  instead  of  protracting  them  over  a  series  of  years 
at  the  expense  of  their  stockholders.  It  is  equally  certain 
that  if  this  policy  had  been  adopted,  a  substantial  dividend 
could  have  been  paid  since  1899,  while  the  physical  efficiency 
of  the  property  would  have  been  fully  as  great  as  it  is  at 
present.  Questions  of  railway  policy,  such  as  this,  are  not 
to  be  judged  by  reference  to  abstract  canons  of  finance,  but 
in  the  light  of  known  conditions  and  with  due  reference  to 
the  rights  of  stockholders. 


CHAPTER   XXI 
THE  ISSUE  OF  STOCK 

Assuming  now  that  funds  are  to  be  raised  for  extensions 
by  the  sale  of  securities,  the  first  question  concerns  the  class 
of  securities  to  be  sold.  Shall  the  corporation  increase  its 
stock  or  shall  it  borrow  the  money  needed? 

The  capital  stock  of  a  company  represents  its  ownership. 
This  ownership  is  divided  into  shares.  An  increase  of  the 
amount  of  stock,  therefore,  increases  the  number  of  owners. 
If  there  is  to  be  only  one  kind  of  stock,  the  shareholders  have 
two  alternatives  when  it  is  proposed  to  increase  the  capital. 
They  may  take  the  new  stock  themselves,  in  which  case  their 
respective  shares  of  participation  in  the  company's  profits 
remain  unchanged,  or  they  may  offer  it  for  general  subscrip- 
tion'. If  a  corporation  has  $10,000,000  of  capital  and  pro- 
poses to  add  $1,000,000,  each  stockholder  of  record  would 
have  the  right*  under  the  law,  to  participate  in  the  increase, 
if  the  stock  was  to  be  sold  for  money,  and  not  exchanged 
for  some  form  of  property.  The  holder  of  one  hundred 
shares  of  stock,  for  example,  would  be  allowed  to  subscribe 
to  ten  shares  of  the  new  stock,  which  would  give  him  the 
same  proportion  of  interest  in  the  corporation  that  he  had 
before.  It  frequently  happens,  however,  that  existing  stock- 
holders do  not  care  to  take  the  entire  issue.  Stock  must  then 
be  sold  to  outsiders,  who  are  admitted  to  participation  in 
^the  earnings,  and  to  share  in  the  control  of  the  company 
on  equal  terms  with  the  existing  stockholders. 

To  the  controlling  interest  of  the  company,  the  admission 
of  new  stockholders  is  often  a  matter  of  great  concern. 
19  277 


278  COKPOKATION  FINANCE 

New  stock  coming  upon  the  market  may  be  absorbed  by 
those  who  desire  to  wrest  control  from  those  who  now  hold 
it.  And  if,  as  usually  happens,  the  control  represents  no 
more  than  a  strong  minority,  this  may  be  the  outcome  of 
an  increase  in  the  capital  stock.  A  celebrated  instance  of 
this  result  is  the  ousting  of  Mr.  August  Belmont  and  his  asso- 
ciates from  the  directorate  of  the  Louisville  &  Nashville  in 
1902.  Early  in  that  year  the  directors  of  the  Louisville  & 
Nashville,  in  order  to  finance  some  extensions,  authorized  the 
sale  of  50,000  shares  of  stock.  Under  the  rule  of  the  New 
York  Stock  Exchange,  shares  are  not  deliverable  on  contracts 
until  thirty  days  after  they  have  been  issued.  Funds  were 
needed  immediately,  however,  and  in  order  to  obtain  them  the 
chairman,  Mr.  Belmont,  was  instructed  by  the  Board  to  sell 
50,000  shares  "  short " — that  is  to  say,  he  sold  stock  which  he 
did  not  own,  borrowed  the  stock  to  deliver  what  he  had  sold, 
and  expected  to  take  up  the  loan  out  of  the  new  shares  when 
these  should  have  become  deliverable.  At  the  same  time,  how- 
ever, unknown  to  the  Belmont  interests,  a  syndicate,  headed 
by  Mr.  John  W.  Gates,  was  engaged  in  a  campaign  to  purchase 
control  of  the  company,  and,  in  the  course  of  their  operations, 
they  developed  a  short  interest  estimated  at  120,000  shares, 
including  the  50,000  shares  sold  by  Mr.  Belmont. 

The  directors  of  the  Louisville  &  Nashville  had,  in  other 
words,  sold  more  shares  than  they  owned,  and  they  could  ob- 
tain the  stock  to  make  their  deliveries  only  from  the  S5rndicate 
whose  advantage  it  was  to  bring  about  this  situation.  On 
April  14,  1902,  it  was  discovered  that  a  corner  existed  in 
Louisville  &  Nashville ;  the  price  of  stock  on  this  date  touched 
133  and  a  repetition  of  the  May  panic  of  1901,  which  was' 
brought  about  by  a  similar  operation  in  Northern  Pacific 
stock,  seemed  imminent.  Serious  trouble  was  averted,  how- 
ever, by  the  recognition  that  Mr.  Gates  controlled  the  Louis- 
ville &  Nashville,  and  by  the  taking  over  of  a  majority, 
interest  in  that  company  by  the  Atlantic  Coast  Line  Eail- 
road  at  a  figure  which  rendered  a  large  profit  to  the  John  W.' 
Gates  syndicate. 


THE   ISSUE   OF   STOCK  279 

On  account  of  the  fear  of  such  operations  as  that  which 
has  been  described,  every  effort  is  made,  when  new  stock 
is  issued,  to  induce  the  existing  stockholders  to  increase  their 
holdings,  or,  failing  in  this,  to  obtain  assurance  that  the  new 
interest  shall  not  only  be  such  as  will  strengthen  the  posi- 
tion of  the  company,  but  will  not  be  unfriendly  to  those  in 
control.  The  strongest  inducement  which  can  be  offered  to 
the  stockholders  is  to  sell  them  a  safe  investment  at  a  low 
price  and  the  lowest  price  which  the  law  allows  is  par,  the 
figure  at  which  stock  is  usually  offered  to  stockholders.  This 
prohibition  against  the  sale  of  stock  below  par  (unless  such 
a  step  is  necessary  to  save  the  company  from  embarrass- 
ment), limits  the  opportunity  to  raise  capital  by  the  sale  of 
common  stock  to  companies  whose  profits  and  dividends  are 
so  large  that  their  stocks  sell  above  par. 

The  common  stock  of  prosperous  companies  frequently 
sells  at  a  high  premium.  For  example,  the  current  price  of 
the  Canadian  Pacific  is  181|;  of  the  Great  Northern,  131J; 
of  the  General  Electric,  146 ;  of  the  Chicago  &  Northwestern, 
147|;  and  of  the  Union  Pacific,  176|.i 

The  existence  of  these  premiums,  which  reflect  high  divi- 
dends and  assured  earning  power,  make  possible  the  plan 
of  financing  the  capital  requirements  of  such  strong  com- 
panies by  the  issue  of  common  stock  on  such  terms  as  to 
induce  stockholders  to  enlarge  their  holdings.  This  plan 
is  known  as  the  sale  of  privileged  subscriptions.  Under  the 
law,  the  stock  of  a  corporation,  as  already  noted,  must  first 
be  offered  to  the  existing  stockholders  who  have  the  right 
to  participate  in  all  new  issues.  Only  in  case  they  are  un- 
willing to  accept  the  terms  offered,  can  stock  be  opened  to 
general  subscription.  Stock  can,  of  course,  be  issued  in  ex- 
change for  property. 

Suppose  that  the  stock  sells  at  a  premium.     The  new 

issues  can  then  be  either  offered  to  the  stockholders  at  a  price 

above  par,  or  an  offer  can  be  made  on  such  a  basis  as  to 

prefer  the  existing  stockholders  in  the  subscription.    In  case 

»  May  2, 1910. 


280  COEPOKATION   FINANCE 

the  market  value  of  the  stock  is  realized  by  offering  stock 
at  a  premium,  a  smaller  number  of  shares  need  be  sold  to 
obtain  a  given  amount  of  capital  than  if  stock  is  sold  at 
par.  Suppose,  for  example,  that  $1,000,000  is  required  by 
a  company  whose  stock  can  be  sold  at  150,  paying  eight 
per  cent  dividends.  If  the  stock  is  sold  at  market  value, 
6,666  shares  will  be  needed  to  obtain  the  $1,000,000  necessary. 
If  it  is  sold  at  par,  however,  10,000  shares  will  be  required. 
The  amount  necessary  to  pay  the  eight  per  cent  dividend 
on  6,666  shares  is  $53,338,  while  on  10,000  shares  $80,000  • 
would  be  required.  If  the  stock  is  sold  at  a  premium,  $27,- 
672  of  annual  dividends,  assuming  that  the  eight-per-cent 
rate  is  continued,  can  be  saved  for  the  company,  over  the 
disbursements  which  must  be  made  if  the  stock  is  sold  at 
par.  As  a  result,  the  rate  of  dividend  can  perhaps  be  in- 
creased, and  the  price  of  the  stock  advanced  on  the  strength 
of  its  larger  dividend  returns. 

In  view  of  these  facts,  the  directors  may  insist  that  they 
should  make  the  best  bargain  possible  for  the  company,  that 
the  stockholder  shall  derive  no  special  or  exceptional  ad- 
vantage from  his  position  as  part  owner  of  the  corporation; 
that  he  should  be  treated  in  the  same  way  as  any  investor. 
Furthermore,  under  the  plan  of  selling  stock  at  a  premium, 
the  dividends  paid  by  the  company,  and  the  price  of  the 
stock  will  show  its  true  earning  power.  No  more  stock  will 
have  been  issued  than  is  necessary  to  provide  the  amount  of 
money  required  for  the  desired  improvements.  The  higher 
the  price  of  the  stock  ascends,  borne  up  on  the  rising  tide 
of  dividends,  the  smaller  will  be  the  number  of  shares  to  be 
sold  to  obtain  the  same  amount  of  money.  The  Pennsylvania 
Eailroad  Company,  for  example,  has  received  large  sums  as 
premiums  on  stocks  sold.  Without  these  premiums,  which 
were  invested  in  the  business,  the  outstanding  stock  of  the 
Pennsylvania  might  have  been  materially  greater  than  it 
now  is. 

On  the  other  hand,  if  stock  is  sold  at  par,  or  at  less  than 
market  price,  the  corporation  must  issue  a  larger  number  of 


THE   ISSUE   OF   STOCK  281 

shares  than  may  conceivably  be  required.  It  may  be  impos- 
sible, on  account  of  the  issue  of  this  extra  stock,  to  do  more 
than  maintain  the  regular  dividend,  and  the  price  of  the  stock, 
therefore,  may  not  advance  to  the  point  which  it  would  reach 
did  the  directors  refuse  to  sell  more  shares  of  ownership  than 
are  necessary  to  obtain  the  money  required. 

'  In  the  case  of  Public  Service  corporations,  the  principle 
has  been  conclusively  established  in  most  of  the  leading  states 
that  they  shall  not  be  allowed  to  earn  more  than  a  fair  return 
on  the  value  of  their  property,  and  it  has  also  been  considered 
important  in  some  states  that  a  corporation  should  not  in- 
crease its  capital  stock  beyond  the  amount  actually  necessary 
to  secure  funds  for  capital  expenditures.  In  Massachusetts, 
for  example,  the  issue  of  all  bonds  and  of  any  increase  of 
stock  in  excess  of  the  original  capital  is  limited  to  such 
amount  as  the  railroad  commissioners  shall,  after  a  public 
hearing,  determine  will  realize  the  sum  which  has  been  prop- 
erly expended,  or  will  be  reasonably  required  by  the  corpora- 
tion for  corporate  purposes.  As  a  rule,  however,  a  company 
whose  stock  sells  at  a  premium  does  not  attempt  to  obtain 
any  part  of  the  premium  by  a  public  offering,  but  offers  its 
stock  to  its  owners  at  par.  Such  a  sale  is  called  the  offer 
of  a  privileged  subscription. 

The  stockholder  receiving  the  privilege  can  avail  himself 
of  it  either  by  selling  his  right  to  subscribe  to  the  stock, 
which  is  made  negotiable  for  the  purpose,  or  by  selling  a 
certain  portion  of  his  existing  holdings  after  he  receives  the 
evidence  of  his  right  to  subscribe,  at  the  existing  market  price, 
replacing  these  shares  at  par  out  of  the  new  issue,  or  he  can. 
retain  his  stock  and  take  the  new  shares  as  well.  In  the 
first  two  cases  mentioned — namely,  the  sale  of  the  negotiable 
right  to  subscribe,  or  the  sale  at  the  market  price  of  an 
amount  of  stock  equal  to  that  to  which  the  stockholder  is 
entitled  to  subscribe  at  par — he  makes  a  profit  which  approx- 
imates the  market  premium  of  the  stock,  times  the  number 
of  shares  which  he  sells.  Since  the  right  will  only  be  pur- 
chased by  some  one  desirous  of  becoming  a  subscriber  to  the 


282  CORPORATION   FINANCE 

stock,  its  price  is  usually  less  than  the  difference  between 
par  and  market  value.  Unless  the  intending  subscriber  can 
obtain  his  new  stock  at  a  lower  price  by  purchasing  a  right, 
he  will  prefer  to  buy  the  stock  direct. 

The  value  of  some  of  these  privileges  has  been  very  great. 
In  an  article  in  the  Quarterly  Journal  of  Economics  for  Febru- 
ary, 1905,  entitled  "  Stockholders'  Profits  from  Privileged 
Subscriptions,"  Dr.  T.  W.  Mitchell  has  computed  the  profits 
which  could  have  been  realized  by  stockholders  of  the  lead- 
ing railroad  companies  which  have  issued  privileged  sub- 
scriptions. Dr.  Mitchell  finds  that  if, a  stockholder  of  the 
Illinois  Central  had  purchased  100  shares  at  a  price  of  135 
per  share  in  1887,  he  would  have  received  between  that  date 
and  1903  eight  privileges-  If  he  had  sold  the  number  of 
shares  to  which  he  was  entitled  to  subscribe  immediately  after 
receiving  his  privilege  and  had  invested  the  proceeds.  Dr. 
Mitchell  finds  that,  from  1887  to  1903,  he  would  have  re- 
ceived from  all'  of  his  eight  privileges  a  total,  principal  and 
interest,  of  $5,740.  This  is  equivalent  to  a  return  of  $222 
a  year  during  the  seventeen  years  of  his  investment,  or  1.64 
per  cent  which  would  have  been  added  to  the  regular  divi- 
dends on  this  stock.  A  man  making  a  similar  purchase  in 
1895,  would  have  received  from  his  five  privileges  a  total 
of  $2,953,  which  is  equivalent  to  $265,  or  2.73  per  cent,  a 
year.  Stockholders  who  made  their  investments  in  1900, 
1901  and  1902  respectively  have  made,  according  to  Dr. 
Mitchell,  from  privileges  alone,  4|  to  5^  per  finnum  on  their 
investment,  and  that,  too,  when  their  original  purchases  were 
made  at  high  premiums.  The  Great  Northern  has  also  been 
very  liberal  to  its  stockholders.  Since  1893  the  stock  of  this 
company  has  sold  above  par.  All  the  stock  issues  of  the 
company  after  the  first,  with  one  exception,  have  been  dis- 
tributed, pro  rata,  among  the  stockholders  of  the  road  at 
par.  The  market  value  of  the  stock  at  the  time  these  various 
issues  were  distributed  ranged  from  $140  to  $264  per  share. 
The  stockholder  could,  therefore,  have  paid  $100  per  share  for 
his  new  stock,  and  could  at  once  have  sold  it  upon  the 


THE   ISSUE   OF   STOCK  283 

market  for  a  much  higher  price,  realizing  from  the  trans- 
action from  $40  to  $164  per  share. 

If  the  stockholder  does  not  care  to  sell  his  right  to  sub- 
scribe, or  to  part  with  any  of  his  stock,  the  privilege  gives 
him  an  opportunity  to  increase  the  return  he  receives  on 
his  investment.  Suppose  he  has  purchased  the  stock  of  a 
company  paying  six  per  cent  dividends  for  $150.  His  return 
is  four  per  cent.  The  company,  within  five  years  after  he 
has  purchased  the  stock,  offers  to  stockholders  the  privilege 
of  subscribing  to  new  stock  at  par  to  an  amount  equal  to 
eighty  per  cent  of  their  holdings.  This  stockholder,  instead 
of  selling  the  right  to  the  stock,  prefers  to  increase  his  invest- 
ment on  the  favorable  terms  offered.  At  the  end  of  five 
years,  he  owns  180  shares  on  which  the  annual  return  is  $6 
per  share,  or  $1,080,  on  an  investment  of  $23,000,  or  4.7 
per  cent.  There  is  little  doubt  that  this  is  the  course  fol- 
lowed by  the  majority  of  stockholders  when  privileges  are 
offered  to  them.  By  the  correct  method  of  computing  the 
yield  on  investments,  the  return  on  a  stock  should  be  obtained 
by  dividing  into  the  rate  of  dividends,  not  the  cost  price,  but 
the  market  price.  An  investor  who  takes  advantage  of  a 
privilege  to  buy  a  six  per  cent  stock  for  $100  per  share  which 
is  selling  on  the  exchange  at  $150,  has  only  a  four  per  cent 
investment,  since  a  share  of  stock  represents  to  him  $150  of 
capital  and  $6  of  income.  The  investor,  however,  estimates 
the  return  by  comparing  the  cost  of  the  stock  with  the  rate  of 
dividend,  and  this  belief  influences  him  to  hold  fast  to  stock, 
new  issues  of  which  are  occasionally  sold  at  less  than  market 
value.  In  no  other  way  could  the  failure  of  shares  to  show 
heavy  declines  after  the  announcement  of  privileges  be  ex- 
plained. Some  decline  is  usually  experienced  following  the 
announcement  of  a  privilege,  but  it  is  seldom  sufficient  to  war- 
rant the  conclusion  that  a  large  number  of  stockholders  are 
disposing  of  their  shares.  There  is  no  reason  for  them  to  do 
so  if  they  have  confidence  in  the  value  of  the  stock,  since  they 
can  take  their  profit  at  any  time  by  selling  at  a  premium  stock 
which  they  purchased  at  par. 


284  COEPOKATION  FINANCE 

When  a  corporation  increases  its  issue  of  stock,  it  must 
keep  in  mind  not  merely  the  amount  of  money  which  the 
new  stock  will  bring,  but  the  effect  of  the  issue  upon  the 
composition  of  the  stockholding  constituency;  the  necessity 
that  the  subscription  should  be  a  success  and  that  the  money 
should  be  promptly  forthcoming;  the  desirability  of  being 
able  to  receive  new  capital  from  the  stockholders  when  re- 
quired, no  matter  what  the  condition  of  the  money  market 
and  to  any  amount  that  may  be  necessary;  the  justice  and 
expediency  of  extending  to  stockholders  more  liberal  treat- 
ment in  the  matter  of  subscription  than  they  extend  to  out- 
siders ;  and,  finally,  the  fact  that  the  sale  of  a  privilege  is 
equivalent  to  an  increase  in  the  rate  of  dividends. 

Let  us  take  up  these  considerations  in  order.  The  sale 
of  stock  at  a  high  premium  means  that  new  interests  are 
brought  into  a  company,  and  that  its  stockholders  are  con- 
tinually changing.  Existing  stockholders,  many  of  whom 
will  have  purchased  the  stock  at  much  lower  prices  than 
those  prevailing  at  the  time  an  attempt  is  made  to  secure  a 
premium  from  a  new  issue,  will  have  no  inducement,  other 
than  their  general  confidence  in  the  company,  to  increase 
their  holdings  on  less  favorable  terms  than  those  which  they 
previously  secured.  Under  these  circumstances,  therefore, 
while  a  large  amount  of  the  new  stock  may  be  taken  by  exist- 
ing stockholders,  it  is  fairly  certain  that  much  of  it  will  be 
sold  to  outsiders.  These  new  interests  may  have  their  own 
preferences  for  directors  and  ofiicers,  and  their  influence  may 
be  sufficient  to  disturb  the  management  and  control.  When, 
however,  stock  is  sold  at  par  with  a  valuable  privilege  at- 
tached, based  on  the  existence  of  a  high  premium  in  the 
market,  the  stock  is  very  closely  held  for  investment.  Little 
stock  is  offered  for  sale,  since  the  stockholder  of  record  knows 
that,  from  time  to  time,  in  addition  to  the  yield  on  the  stock 
represented  by  a  comparison  between  the  purchase  price  and 
the  dividend  paid,  he  will  have  an  opportunity  to  increase 
his  investment  on  more  favorable  terms  than  if  he  desires 
to  gain  an  immediate  profit  in  one  of  the  ways  described. 


.     THE   ISSUE   OF   STOCK  '     285 

The  election  of  such  a  course  of  action  by  the  stockholder 
is  the  more  certain  when  it  is  remembered  that  the  values  of 
stock  privileges  are  not,  as  a  rule,  fully  capitalized  in  the 
value  of  the  stock.  If  a  corporation  would  announce  that 
on  January  1st  of  each  year  its  stock  would  be  increased 
ten  per  cent,  and  that  stockholders  of  record  would  have  the 
privilege  of  subscribing  to  the  new  stock  at  par,  then  the 
value  of  the  privilege  would  be  expressed  in  the  market  value 
of  the  stock,  which  would  be  established  on  a  permanently 
higher  level.  No  such  assurance  can,  however,  be  given  to 
the  stockholders.  The  directors  will  follow  the  policy  which 
seems  best  at  the  time.  They  cannot  limit  themselves  in 
the  methods  which  they  will  employ  for  raising  new  capital. 
It  is  impossible,  therefore,  that  these  privileges  should  be 
counted  upon  at  any  particular  time  and  to  any  particular 
amount.  They  are  incidental  and  fortuitous  gains  to  the 
stockholder,  gains  which  he  has  every  reason  to  believe  he 
will  receive  in  the  future  as  he  has  received  them  in  the  past, 
but  which  will  not  be  fully  reflected  in  the  higher  market 
value  of  the  stock.  To  gain  these  privileges,  therefore,  the 
stockholder  must  retain  his  shares.  It  is  well  known  that 
those  corporations,  such  as  the  Illinois  Central;  Chicago, 
Milwaukee  &  St.  Paul;  Great  Northern;  United  Gas  Im- 
provement Company;  and  New  York,  New  Haven  &  Hart- 
ford Company,  which  have  granted  valuable  privileges,  have 
a  body  of  stockholders  whose  composition  changes  slowly. 

Directors  place  a  high  value  upon  permanence  in  their 
stockholding  body.  Stockholders  of  long  standing  can  be 
counted  on  to  support  the  management.  In  the  unlikely 
event  of  a  contest  for  proxies,  the  limited  supply  of  such  a 
stock  makes  it  very  difficult  and  expensive  for  an  outside 
interest  to  buy  control.  One  of  the  most  serious  difficulties  ex- 
perienced by  Mr.  E.  H.  Harriman  in  his  contest  for  the  con- 
trol of  the  Illinois  Central  in  1907,  was  the  firmness  with 
which  most  of  the  individual  stockholders  supported  Mr.  Stuy- 
vesant  Fish's  administration. 

Another  argument  in  favor  of  selling  stock  at  par  is  that 


\r 


286  COKPOKATION   FINANCE 

the  securing  of  a  premium  on  the  sale  of  a  large  amount 
of  stock  is  an  uncertain  matter,  depending  on  the  condition 
of  the  stock  market,  which  may  change  overnight.  In  order 
to  guarantee  that  a  premium  will  be  secured,  unless  the  sub- 
scription price  is  placed  so  far  below  the  market  price  that 
it  amounts,  in  effect,  to  a  privilege  to  stockholders  of  record, 
the  services  of  an  underwriting  syndicate  must  be  employed. 
The  Pennsylvania  Eailroad,  for  example,  in  1903  offered 
$75,000,000  of  stock  to  holders  of  record  at  $120  a  share. 
The  stock  was  at  that  time  selling  above  150.  No  difficulty 
was  anticipated  in  disposing  of  the  stock  as  offered  in  the 
subscription.  A  general  decline  in  stock  values,  however,  set 
in  which  carried  down  the  value  of  the  Pennsylvania  stock 
with  it.  It  was  feared  that  the  stock  might  fall  below  the 
subscription  price  by  the  date  when  the  subscriptions  were 
to  be  made.  In  this  event  the  credit  of  the  company  would 
have  been  seriously  damaged,  since  the  subscription  offer 
would  have  to  be  withdrawn.  To  guard  against  such  a  con- 
tingency, an  underwriting  syndicate  was  formed,  headed  by 
Speyer  &  Company,  which,  in  return  for  a  commission  of 
$2,250,000,  agreed  to  take  from  the  company  any  of  the 
$75,000,000  of  stock  at  the  subscription  price  of  120  a  share, 
which  the  stockholders  should  not  take.  The  announcement 
of  the  formation  of  this  syndicate  steadied  the  price  which 
had  at  one  time  fallen  to  114^,  and  the  syndicate  had  to 
assume  only  a  small  part  of  its  obligation,  making  a  large 
profit  on  the  transaction.  The  Pennsylvania  Eailroad  is 
probably  the  strongest  railroad  corporation  in  the  world,  and 
its  stock  is  highly  esteemed  by  investors.  On  this  occasion 
the  stock  was  offered  far  below  the  market  price,  and  yet  the 
securing  of  a  premium  was  only  made  possible  by  the  inter- 
vention of  an  underwriting  syndicate. 

On  the  other  hand,  a  corporation  whose  stock  sells  at  a 
high  premium,  and  which  offers  new  issues  to  stockholders  at 
par,  is  never  at  a  loss  to  obtain  new  capital  funds.  Dur- 
ing 1906,  when  the  bond  market  was  seriously  depressed,  and 
when  the  strongest  railroad  and  industrial  corporations,  rather 


THE   ISSUE   OF   STOCK  287 

than  sell  long  term  bonds  on  a  five  per  cent  basis,  were 
resorting  to  the  expedient  of  short  term  notes  paying  five 
and  six  per  cent  interest,  four  of  the  largest  railroad  com- 
panies— the  Great  Northern,  the  Northern  Pacific,  the  Chi- 
cago, Milwaukee  &  St.  Paul,  and  the  Chicago  &  Northwest- 
ern— raised,  among  them,  about  $300,000,000  from  their 
stockholders,  by  the  sale  of  stock  at  par.  If  they  had  gone 
into  the  bond  market,  it  would  have  been  difficult  for  them 
to  obtain  this  amount  of  money.  They  might  have  had  to 
pay  for  three  years  an  interest  rate  of  at  least  six  per  cent  on 
notes  issued  in  anticipation  of  the  sale  of  the  bonds. 

There  is  this  further  to  be  said  in  favor  of  the  sale  of 
stock  on  a  privileged  basis  to  holders  of  record,  that  it  is 
fair  to  the  stockholder  who  does  not  care  to  increase  his 
investment,  and  who  would  not  be  able  to  participate  in  any 
of  the  benefits  of  the  new  issue,  if  it  were  offered  at  a 
premium.  Such  stockholders  receive  their  rights  to  subscribe 
which  they  can  sell  in  the  manner  already  explained,  and  in 
this  way  participate,  although  to  a  less  extent  than  the  stock- 
holders who  hold  their  stock,  in  the  benefits  of  the  new  stock 
issue. 

The  issue  of  premium  stock  at  par  to  stockholders  is  an 
indirect  method  of  distributing  the  company's  surplus  in  the 
sense  that  a  larger  disbursement  must  be  made  on  the  stock 
than  if  this  has  been  sold  at  a  premium.  A  corporation 
which  obtains  $1,000,000  by  selling  10,000  shares  of  stock 
at  par,  when  it  could  have  obtained  the  same  money  by  the 
sale  of  6,666  shares  at  150,  is  assuming  a  larger  burden  than 
is  necessary  to  obtain  the  money.  Its  stock  capital  is  3,333 
shares  larger  than  it  would  have  been  had  the  full  market 
price  been  obtained.  The  dividend  rate  cannot  be  increased 
so  rapidly  as  though  a  smaller  number  of  shares  had  been 
sold  to  obtain  the  amount  required.  For  this  reason,  the 
sale  of  privileged  subscriptions  by  public  service  corpora- 
tions has  been  severely  criticised.  There  is  a  strong  tendency 
in  public  sentiment  to  compel  these  companies  to  sell  their 
stock  to  realize  the  highest  market  price   obtainable,  and 


288  COKPOKATION  riNAITCE 

not  to  favor  stockholders  by  the  sale  of  stock  on  preferential 
terms. 

The  law  usually  does  not  take  cognizance  of  the  market 
value  of  stock.  It  merely  requires  that  the  par  value  should  be 
paid  in  cash,  and  in  the  absence  of  a  special  statute  or  ruling 
to  the  contrary,  the  corporation  has  authority  to  sell  its  stock 
at  par.  Furthermore,  market  value,  as  already  shown,  is  un- 
stable and  uncertain.  The  realization  of  a  given  profit  by  the 
sale  of  a  privilege,  which,  as  we  have  seen,  is  a  course  adopted 
by  only  a  portion  of  the  stockholders  to  whom  privileges  are 
offered,  is  a  doubtful  matter.  The  Interstate  Commerce  Com- 
mission in  the  case  of  the  City  of  Spokane  vs.  Northern 
Pacific  Eailway  Company,  considered  this  question  of  the 
return  from  privileged  subscriptions,  in  reaching  a  conclu- 
sion as  to  the  earnings  of  the  Northern  Pacific.  The  com- 
plainants in  this  case  asserted  that  the  Great  Northern,  one 
of  the  defendants  in  the  case,  had  distributed  its  stock,  from 
time  to  time,  in  such  a  manner  as  to  give  its  stockholders 
large  profits  in  addition  to  their  dividends,  and  insisted 
"  that  this  manner  of  selling  stock  is  vicious  and  unlawful, 
and  that,  in  determining  the  return  to  these  stockholders,  we 
must  have  in  mind  the  benefit  conferred  upon  those  stock- 
holders by  this  operation." 

The  commission,  however,  rejected  this  view  as  follows: 
"Assuming,  without  deciding,  that  the  complainant  is 
right  in  its  position  that  this  practice  is  both  unlawful  and 
unwise,  how  can  we,  in  this  proceeding,  take  any  practical 
note  of  what  has  been  done?  This  stock  is  selling  to-day, 
January,  1908,  upon  the  market  at  something  less  than  $120 
per  share.  If  the  original  stockholder  has  retained  and  now 
owns  his  stock,  he  paid  $100  in  the  beginning,  has  received 
a  regular  dividend,  and  now  owns  his  stock  at  the  above  ad- 
vance. While  the  profit  to  him  has  been  a  handsome  one, 
there  is  certainly  nothing  here  which  would  call  for  a  penal- 
izing of  the  stockholder.  Suppose,  now,  that,  instead  of 
retaining  the  stock,  the  stockholder  sold  the  same  to  some 
innocent  purchaser  who  paid  the  market  price,  and  who  has 


THE  ISSUE   OF  STOCK  289 

continued  to  own  the  stock  from  then  until  now.  This 
present  stockholder  paid  perhaps  $264  a  share  for  his  stock. 
He  has  lost  $144  per  share.  Should  we,  for  that  reason, 
compel  him  to  sustain  a  further  loss  ?  The  manner  in  which 
this  stock  has  been  manipulated  may  furnish  a  strong  argu- 
ment against  the  propriety  of  permitting  the  sale  of  new 
stock  in  this  manner,  but  so  far  as  this  particular  company 
and  the  stock  already  issued  are  concerned,  the  transaction 
is  ended,  and  can  be  given  no  practical  consideration  in 
determining  what  rates  shall  be  charged  by  the  Great  North- 
ern Railway  Company." 

There  is  reason  to  believe  that  the  practice  of  privileged 
subscriptions  will  not  long  be  permitted  without  restrictions 
to  public  service  corporations.  They  will  probably  be  re- 
quired, when  selling  new  stock,  to  obtain  the  highest  pos- 
sible price.  This  does  not,  however,  mean  that  stockholders 
will  no  longer  be  favored  with  opportunities  to  subscribe 
on  preferential  terms,  but  merely  that  the  value  of  the  pref- 
erence may  be  reduced.  If  a  public  service  commission  is 
required  to  authorize  an  issue  of  stock  selling  at  a  premium, 
and  to  name  a  price  at  which  the  stock  can  be  sold,  unless 
they  wish  to  take  the  responsibility  for  a  possible  failure 
of  the  subscription,  they  will  not  insist  that  the  corporation 
should  attempt  to  obtain  the  full  premium  ruling  at  the 
time  the  offer  is  made.  Some  lower  figure  will  be  named, 
and  at  this  figure  the  stockholders  of  record,  to  whom  the 
stock  must  first  be  offered,  will  usually  take  a  considerable 
amount  of  the  new  issues,  especially  if  the  premium  is 
guaranteed  by  an  underwriting  syndicate. 


CHAPTER   XXII 
THE  SALE  OF  PREFERRED  STOCK 

A  CORPORATION  desiring  to  provide  new  capital  from  the 
sale  of  stock  seldom  resorts  to  common  stock  unless  this  is 
selling  at  a  high  premium.  The  law  usually  requires  that 
stock  should  not  be  sold  at  less  than  par  value,  unless  it 
may  be  necessary  to  offer  it  at  a  discount  in  order  to  relieve 
the  company  from  pressing  financial  embarrassment.  When 
a  company  desires  to  offer  stock  at  a  discount,  as  did  the 
"Western  Maryland  recently  in  an  offer  of  common  stock  at 
$50  a  share,  it  is  sometimes  necessary  to  get  permission  from 
the  Legislature  to  offer  the  stock  at  this  low  price.  It  is, 
moreover,  usually  difficult  to  find  a  purchaser  for  stock  at 
a  discount.  A  low  price  indicates  the  general  lack  of  con- 
fidence in  the  ability  of  a  company  to  pay  reasonable  divi- 
dends on  the  *tock.  Until,  therefore,  a  company  has  reached 
an  assured  financial  position,  the  sale  of  common  stock  is 
usually  not  available  as  ■  a  means  of  obtaining  new  capital. 
Failing  common  stock,  there  is  left  for  the  choice  of  the 
directors  either  preferred  stock  or  bonds. 

The  bondholder  has  no  voice  in  the  management  of  the 
corporation.  In  return  for  its  obligation  to  pay  him  a  fixed 
sum  at  regular  intervals,  and  to  secure  him  in  the  re- 
turn of  his  principal  should  he  desire  it,  he  is  willing  to 
forego  participation  in  profits  above  the  amount  of  his  in- 
terest which,  as  a  rule,  does  not  exceed  five  per  cent,  and 
seldom  goes  above  six  per  cent.  The  preferred  stockholder, 
on  the  other  hand,  expects  from  six  to  eight  per  cent  as  a 
preferred  charge  in  advance  of  dividends  upon  the  common 
290 


THE  SALE  OF  PREFEREED  STOCK    291 

stock.  He  also  demands  a  voice  in  the  management  of  the 
company.  So  far  as  the  common  stockholder  is  concerned, 
an  issue  of  bonds,  if  this  can  be  safely  made,  is  usually 
preferable  to  the  sale  of  preferred  stock.  The  common  stock- 
holder's share  of  the  profits  is  larger  if  bonds  are  issued  for 
new  capital,  and  he  is  left  undisturbed  in  the  control  of  the 
company. 

There  are,  however,  opposing  considerations.  Dividends 
on  the  preferred  stock,  even  if  these  dividends  are  made 
cumulative,  although  the  investment  standing  of  the  corpo- 
ration demands  that  they  should  be  paid  if  earned,  need  not 
be  paid.  A  company  may  pile  up  an  unlimited  amount  of 
preferred  dividends,  while  still  remaining  entirely  solvent, 
and  in  a  most  flourishing  condition.  Interest,  on  the  other 
hand,  is  an  absolute  charge  against  income.  It  must  be 
paid,  or  the  courts  will  seize  the  property  of  the  company 
for  the  benefit  of  its  creditors.  When  any  doubt  exists  as 
to  the  ability  of  the  corporation,  in  good  years  as  well  as 
bad  years,  to  earn  interest  on  the  capital  which  it  proposes 
to  secure  by  the  sale  of  bonds,  and  when  the  sale  of  com- 
mon stock  is  not  possible,  then  preferred  stock,  rather  than 
bonds,  should  be  sold.  As  between  preferred  stock  and 
bonds,  if  safety  is  considered  of  primary  importance,  a  con- 
servative management  will  obtain  funds  by  the  issue  of 
stock,  and  will  limit  its  bond  issues  to  the  amount  on  which 
the  smallest  net  earnings  which  the  corporation  is  likely  to 
secure,  will  be  more  than  suflScient  to  pay  the  interest  charges. 
If  this  minimum  of  net  earnings  will  not  pay  interest  on 
the  amount  of  capital  required,  then  preferred  stock  should 
be  issued  to  obtain  the  amount  on  which  interest  cannot  be 
assured. 

In  determining  the  expediency  of  a  bond  issue,  moreover, 
the  starting  point  should  not  be  the  earnings  of  the  com- 
pany, increased  by  the  returns  on  the  improvements  in  which 
it  is  proposed  to  invest  the  new  capital  funds,  but  the  earn- 
ings of  the  company  as  they  stand  before  the  increase  of 
its  liabilities.    The  new  capital  will  probably  be  productive. 


292  CORPORATION  FINANCE 

but  there  is  no  certainty  that  it  will  be  immediately  produc- 
tive, and,  in  the  meantime,  bankruptcy  might  overtake  the 
corporation  if  it  relies  upon  the  issue  of  bonds  to  provide 
the  necessary  funds  for  these  improvements.  Again,  certain 
enterprises,  as  we  have  seen  in  a  preceding  chapter,  do  not 
furnish  proper  security  for  bond  issues.  The  borrowing 
power  of  most  industrial  enterprises  is  limited  to  a  small 
portion  of  their  assets,  in  some  cases,  as  we  shall  see  later, 
to  the  amount  of  their  current  assets.  If  they  wish  to  raise 
additional  capital,  it  must  be  by  the  sale  of  preferred  stock. 

We  have  already  discussed  under  the  "  Preparation  of  the 
Pinancial  Plan  "  the  conditions  under  which  preferred  stock 
can  be  issued,  and  the  safeguards  demanded  by  the  pur- 
chasers of  such  stock  when  put  out  as  a  part  of  the  original 
plan  of  capitalization.  The  precautions  taken  when  pre- 
ferred stock  is  issued  after  the  organization  of  the  com- 
pany usually  include  both  those  safeguards  already  described, 
and  also  supplementary  securities,  which  are  intended  to 
protect  the  preferred  stockholder  against  any  abuse  of  their 
power  by  the  interests  in  control  of  the  company.  The  pur- 
chaser of  preferred  stock  put  out  by  a  going  concern  as  the 
means  of  obtaining  new  capital  occupies  a  different  relation 
to  the  company  from  the  holder  of  the  stock  as  originally 
issued.  In  most  of  the  consolidations,  which  have  furnished 
nearly  all  the  preferred  stock  now  dealt  in  on  the  public 
exchanges,  preferred  stock  was  issued  to  the  owners  of  plants 
which  were  put  into  the  consolidation.  The. original  holders 
of  the  preferred  stock  were,  in  a  sense,  partners  in  the  enter- 
prise, receiving  common  stock  along  with  their  preferred 
stock,  and  not  exacting  any  unusual  guarantees  from  the 
corporation.  When  preferred  stock  is  issued  by  a  going  con- 
cern for  cash,  various  precautions  are  taken  to  make  the  stock 
as  safe  an  investment  as  possible*;  to  give  to  the  holder  of 
preferred  stock  the  nearest  possible  approach  to  the  security 
of  the  bond. 

Preferred  stock  issued  to  obtain  new  capital  is,  with  few 
exceptions,  made  cumulative  both   as  to  dividends  and  to 


THE  SALE  OF  PREFEREED  STOCK    293 

assets.  The  amount  of  the  preferred  stock  issued  under 
these  circumstances  cannot  be  increased  without  the  consent 
of  a  large  majority  of  the  outstanding  stock.  Since  the 
bonds  of  the  company  precede  the  preferred  stock,  precau- 
tions are  taken  to  prevent  any  increase  of  debt  without 
the  consent  of  the  preferred  stockholder.  Preferred  stock, 
when  issued  to  obtain  new  capital,  is  more  likely  to  be  made 
participating  than  when  included  in  an  original  issue.  The 
common  stock  originally  issued  has  by  this  time  been  sold, 
no  syndicate  has  any  common  stock  which  must  be  favored, 
and  it  may  be  necessary  to  give  to  the  preferred  stock  the 
right  to  participate  in  dividends  in  order  to  make  it  attrac- 
tive to  the  investor.  Preferred  stock  issued  to  obtain  new 
capital  is  also  more  likely  to  carry  with  it  special  voting 
powers. 

An  effort  is  sometimes  made  in  preferred  stock  contracts 
to  enforce  conservative  management  upon  the  company.  This 
is  a  new  feature,  but  has  been  quite  prominent  in  recent 
issues.  The  danger  to  the  preferred  stockholder  is  that 
the  company  shall  make  excessive  disbursements  in  common 
stock  dividends,  so  that  the  necessary  surplus  will  not  be 
accumulated.  Every  dollar  which  the  preferred  stockholder 
can  withhold  from  common  stock  dividends  is  so  much  gained 
in  the  greater  security  of  his  stock.  This  reservation  of 
profits  may  be  made  by  including  in  the  contract  with  the 
stockholder  the  obligation  of  the  corporation  to  build  up  a 
reserve  fund  out  of  profits  in  advance  of  common  stock 
dividends.  A  typical  provision  of  this  character  appears 
in  the  recent  issue  of  preferred  stock  by  the  Underwood 
Typewriter  Company. 

The  charter  of  the  company  contains  the  following, 
amoiig  other  provisions,  for  the  protection  of  the  preferred 
stock : 

There  shall  be  set  apart  from  the  net  profits  of  the 
Company  at  the  rate  of  not  less  than  $100,000  per  an- 
num, a  fund  to  be  known  as  "  SPECIAL  SURPLUS 
CAPITAL  RESERVE  ACCOUNT,"  which  shall  be 
30 


294  COEPORATION  FINANCE 

made  and  kept  good  at  the  rate  of  $100,000  per  an- 
num for  each  year  before  any  dividends  shall  be  paid 
on  the  common  stock,  and  after  the  expiration  of 
three  years  from  the  date  of  incorporation  of  the 
Company  said  SPECIAL  SURPLUS  CAPITAL  RE- 
SERVE ACCOUNT  shall  be  used  annually  in  the 
purchase  and  retirement  of  said  preferred  stock  at  the 
lowest  price  at  which  the  same  may  be  obtainable, 
but  in  no  event  exceeding  a  premium  of  twenty-five  per 
cent  over  and  above  the  par  value  thereof.  Such  pur- 
chases may  be  made  at  the  option  of  the  Company 
either  at  public  or  private  sale,  and  all  preferred  stock 
so  acquired  shall  be  canceled. 

The  Company  shall,  in  no  event,  pay  or  declare  any 
dividends  on  the  common  stock  until  the  annual  sum 
of  $100,000  shall  have  been  first  set  aside  and  paid 
into  the  SPECIAL  SURPLUS  CAPITAL  RESERVE 
ACCOUNT  for  the  purchase  and  retirement  of  pre- 
ferred stock,  nor  as  long  as  there  shall  be  any  arrears 
in  respect  of  such  SPECIAL  SURPLUS  CAPITAL 
RESERVE  ACCOUNT,  and  no  dividend  in  excess  of 
four  per  cent  shall  be  declared  or  paid  on  the  common 
stock  until  and  unless  there  shall  first  have  been  ac- 
cumulated and  set  aside  from  and  out  of  the  net  earn- 
ings of  the  corporation  the  sum  of  $1,000,000  by  way 
of  surplus  to  the  credit  of  said  SPECIAL  SURPLUS 
CAPITAL  RESERVE  ACCOUNT,  either  in  the 
form  of  cash  or  its  equivalent  or  of  retired  and  can- 
celed preferred  stock  of  the  par  value  of  $1,000,000. 
This  SPECIAL  SURPLUS  CAPITAL  RESERVE 
ACCOUNT  may  be  used  for  the  payment  of  dividends 
on  the  preferred  stock  provided  there  are  no  other 
*  funds  applicable  for  that  purpose,  and  provided  further 
that  all  encroachments  upon  or  arrears  in  said  fund 
shall  be  made  good  out  of  future  earnings  before  any 
dividends  whatever  shali  at  any  time  be  paid  or  de- 
clared on  the  common  stock. 

The  charter  of  the  American  Piano  Company  which  re- 
cently offered  preferred  stock,  provides  that: 

No  dividend  on  the  common  stock  can  at  any  time 
be  paid  either  in  cash  or  otherwise  if  such  payment 


THE  SALE  OF  PREFERRED  STOCK    295 

would  reduce  the  actual  surplus  of  the  company  to  an 
amount  less  than  ten  per  cent  of  the  par  value  of  the 
total  amount  of  the  issued  and  outstanding  preferred 
stock ;  nor,  when  the  actual  surplus  of  the  company  is 
less  than  fifty  per  cent  of  the  par  value  of  the  total 
issued  and  outstanding  preferred  stock,  shall  any  divi- 
dend on  the  common  stock  be  declared  or  paid  unless, 
at  the  time  of  the  declaration  thereof,  there  shall  be 
added  to  the  surplus,  out  of  the  net  profits,  an  amount 
equal  to  not  less  than  one  third  of  the  total  common 
•  stock  dividend  declared. 

These  provisions  are  included  in  the  fundamental  con- 
tract between  the  preferred  stockholders  and  the  corporation; 
they  can  be  strictly  enforced  against  the  company;  and  they 
furnish  a  large  measure  of  protection  to  the  preferred  stock- 
holders against  a  too  liberal  management  of  income  by  the 
directors. 

A  feature  which  is  usual  in  preferred  stock  contracts, 
when  the  issue  is  made  to  procure  new  capital,  is  the  right 
of  redemption.  Ordinary  issues  of  preferred  stock  do  not 
often  contain  such  a  right.  When  the  common  stockholders 
have  consented  to  placing  six  or  seven  per  cent  preferred 
stock  ahead  of  their  own  right  to  participate  in  the  profits 
of  the  company,  it  is  fair  to  them,  in  case  the  earnings  of 
the  company  improve  to  the  point  where  a  lower  dividend 
preferred  stock  or  some  form  of  bond  may  be  sold,  that 
they  should  be  allowed  to  retire  the  preferred  stock.  When 
a  large  part  of  the  issue  of  preferred  stock  has  been  taken 
by  the  common  stockholders  who  safeguard  themselves  by 
the  preferred  claim,  these  stockholders  may  wish  to  partici- 
pate in  the  earnings  of  the  company  to  a  larger  amount  than 
that  to  which  their  preferred  stock  entitles  them.  If  their 
contract  allows  them  equal  participation  with  the  common 
stock  in  all  dividends  over  the  prescribed  rate  on  the  pre- 
ferred stock,  there  is  no  advantage,  from  their  point  of 
view,  in  retiring  the  preferred.  If,  however,  this  right  of 
equal  participation  has  not  been  given,  and  it  is  unusual; 
they  may  desire  to  exchange  their  preferred  stock  for  com- 


296  COEPORATION   FINANCE 

mon  stock,  if  the  increasing  earnings  of  the  company  make 
such  a  course  attractive.  It  often  happens,  moreover,  that 
the  preferred  stock  has  been  given,  as  an  extra  measure  of 
protection,  the  right  to  elect  a  majority  of  the  board  of 
directors.  In  such  a  case,  the  common  stockholder  is  natu- 
rally anxious  to  regain  control  by  retiring  the  preferred.  For 
the  protection  of  the  preferred  stockholder,  however,  and  not 
to  make  his  investment  in  this  stock  unattractive,  the  right 
of  compulsory  retirement  or  redemption  is  usually  fixed  at  a 
point  well  above  par,  usually  not  less  than  110.  The  right  of 
redemption  may  terminate  at  the  end  of  a  given  number  of 
years,  or  may  not  begin  until  the  expiration  of  a  period. 

When  issued  under  proper  safeguards,  and  by  a  prosper- 
ous company  which  is  paying  dividends  on  its  common  stock, 
cumulative  preferred  stock  is  coming  to  be  regarded  as  an 
attractive  investment,  and  is  in  increasing  demand.  While 
there  is  no  reason  to  believe  that  companies  will  ever  be  able 
to  obtain  capital  by  tlie  issue  of  such  a  security  on  as  favor- 
able terms  as  by  issuing  bonds,  yet  it  is  reasonably  sure  that 
preferred  stock  will  be  sold  on  terms  more  favorable  to  the 
corporation  than  those  which  now  prevail. 


CHAPTER   XXIII 
THE  ISSUE  OF  EVIDENCES  OF  DEBT 

The  method  of  providing  new  capital  for  corporations  of 
established  credit  and  assured  earnings,  which  is  steadily 
growing  in  popularity,  is  the  method  of  borrowing.  As  be- 
tween the  issue  of  preferred  stock  and  bonds,  when  the 
conditions  of  the  company  permit  the  issue  of  bonds,  this 
method  is  usually  selected.  The  bondholder,  in  return  for  a 
secured  claim  to  a  fixed  return  on  the  obligations  which  he 
buys,  leaves  the  stockholder  in  possession  of  the  property  of 
the  company,  and  in  the  enjoyment  of  all  its  profits  over  the 
amount  necessary  to  pay  interest,  and,  where  this  is  provided, 
the  appropriation  to  build  up  a  sinking  fund.  Because  of  the 
security  given,  moreover,  the  rate  of  return  which  the  bond- 
holder exacts  is  much  less  than  would  be  demanded  by  the 
holder  of  preferred  stock.  If  the  company  can  borrow  money 
for  extensions  and  improvements,  therefore,  the  surplus  re- 
maining for  the  stockholders,  after  providing  for  a  return  on 
the  new  capital  required,  is  usually  two,  and  sometimes  three 
per  cent  greater  than  if  preferred  stock  is  issued.  These 
reasons  for  the  issue  of  evidences  of  debt  rather  than  pre- 
ferred stock  are,  in  almost  all  cases,  controlling. 

The  evidences  of  debt  which  may  be  issued  by  a  cor- 
poration seeking  new  capital  may  be  divided  into  short  term 
loans  and  long  term  bonds.  The  first  class  may  be  again 
divided  into  bank  loans  and  short  term  notes.  We  shall 
consider  these  in  their  order. 

Bank  loans  are  made  in  anticipation  of  the  proceeds  of 
business  transactions  which  will  mature  in  the  near  future.  It 
is  unsafe  for  a  bank  to  advance  money  to  be  put  into  any 

297 


298  COKPOKATION   FINANCE 

form  of  fixed  capital  which  will  do  no  more  than  return  a 
safe  margin  over  the  interest  on  the  loan.  Bank  loans  must 
be  either  paid  when  due,  principal  and  interest,  or  materially 
reduced.  Experience  shows  that  permanent  capital  cannot 
be  obtained  from  the  commercial  bank.  *  The  business  of  the 
/bank  is  to  supply  the  temporary  needs  of  business  for  work- 
fing  capital.  Nearly  every  business  is,  to  some  extent,  sea- 
'  sonal  in  its  character.  The  agricultural  implement  dealer, 
who  sells  to  the  farmer,  may  deliver  machinery  in  the  spring 
and  wait  until  after  harvest  for  payment.  In  the  fall,  when 
he  has  collected  for  the  season's  sales,  and  has  only  begun  to 
manufacture  for  next  season,  there  will  be  no  need  for  the 
implement  manufacturer  to  borrow  largely  from  the  banks. 
The  amount  of  capital  locked  up  in  machinery  sold,  will,  how- 
ever, steadily  increase  as  the  season  advances,  until,  before 
harvest,  he  will  have  a  large  temporary  investment  in  notes 
and  accounts.  It  is  not  considered  economical  that  the  manu- 
facturer should  have  invested  sufficient  capital  to  carry  his 
business  for  the  entire  year  without  resort  to  the  banks*  If 
such  a  policy  be  decided  on,  for  a  part  of  the  year,  the  manu- 
facturer would  have  on  hand  a  large  amount  of  capital  on 
which  he  might  be  paying  six  per  cent  dividends  while  receiv- 
ing only  three  per  cent  for  it  from  the  banks. 

The  manufacturer  of  agricultural  implements  obtains  notes 
from  his  customers,  and  these  notes  are  used  as  collateral 
for  his  own  notes,  which  are  sold  to  banks.  When  the  notes 
mature  they  are  paid  out  of  the  proceeds  of  collections.  This 
illustration  shows  the  principal  contribution  of  the  banks  to 
the  working  capital  of  industry.  Banks  sometimes  extend 
permanent  credit  to  concerns  which  are  growing  rapidly  and 
require  an  increasing  working  capital,  but  the  bank's  contri- 
bution will  be  only  a  portion  of  the  working  capital  of  the 
business.  It  is  better  that  a  company  should  provide  for  the 
normal  amount  of  working  capital,  resorting  to  the  banks  to 
supply  the  seasonal  demands  for  capital,  and  any  extraordi- 
nary demands  to  meet  which  permanent  provision  cannot  be 
made. 


THE   ISSUE   OF   EVIDENCES   OF   DEBT       299 

Bank  loans  are  not  available  as  a  source  of  permanent  I 
capital,  although  they  may  furnish  a  portion  of  the  capital/ 
which   a  corporation  requires.     In   some  cases,  however,   a/ 
special  form  of  obligation,  either  secured  or  unsecured,  is 
favored  by  corporations,  and  largely  sold  to  banks  as  well  as 
to  investors.    This  is  known  as  the  short  term  note.     Such 
obligations  run  for  one,  two,  or  three  years,  and  pay  a  high     ^ 
rate  of  interest — five  or  six  per  cent.     This  form  of  obliga- 
tion is  usually  resorted  to  during  periods  of  stringency  in 
the  money  market,  when  long  term  bonds  cannot  be  sold 
except  on  the  basis  of  a  high  interest  yield. 

A  first-class  railroad  corporation  expects,  under  normal 
conditions  of  demand,. to  sell  its  first  mortgage  four  per  cent 
bonds  at  par.  The  money  market  may,  however,  get  into 
such  a  condition  that  a  four  per  cent  bond  of  this  class 
cannot  be  sold  except  at  a  price  to  yield  five  per  cent  to 
the  investor.  Suppose  the  corporation  wishes  to  issue  a  thir- 
ty year  bond.  If  it  makes  the  issue  at  such  a  time,  it  will 
have  to  pay  the  one  per  cent  extra  for  thirty  years,  or  thirty 
per  cent  on  the  entire  amount  of  the  issue.  Looking  at  the 
proposition  solely  from  the  standpoint  of  income,  and  as- 
suming that  an  improvement  in  the  bond  market  will,  within 
two  or  three  years,  make  it  possible  to  again  sell  four  per 
cent  bonds  at  par,  it  is  advantageous  for  a  company,  in  the 
circumstances  described,  to  borrow  the  amount  required  for, 
say,  three  years,  paying  six  or  seven  per  cent  interest,  and 
trusting  to  its  ability  to  refund  the  obligation  at  maturity 
on  a  four  per  cent  basis.  Instead  of  paying  thirty  per  cent 
premium,  therefore,  the  company  which  makes  an  issue  of  two 
year  six  per  cent  notes,  and  refunds  these  on  a  four  per  cent 
basis,  will  only  pay  four  per  cent  premium  for  the  money  over 
the  entire  period. 

The  conditions  under  which  the  issue  of  short  term  notes 
is  advantageous  are  illustrated  by  the  situation  of  the  Amer-  ?. 
ican  money  market  in  1906.     During  this  year,  the  bond 
market  had  been  extremely  dull.     Prices  generally  declined; 
issues  yielding  less  than  four  and  a  half  per  cent  gained 


300  COKPOKATION   FINANCE 

little  attention.  The  explanation  was  found  in  the  high  rates 
for  money.  The  largest  bond  buyers  are  the  financial  insti- 
tutions, banks,  savings  banks,  trust  companies,  and  insurance 
companies.  During  1906,  these  large  bond  buyers  were  able 
to  lend  their  funds  on  call  through  the  banks,  or  to  pur- 
chase commercial  paper  at  very  high  rates  of  interest,  and 
with  perfect  security.  As  a  result,  they  reduced  their  bond 
purchases.  As  an  illustration  of  the  stringency  of  money  pre- 
vailing during  this  year,  may  be  cited  the  case  of  one  of 
the  largest  manufacturing  concerns  in  Philadelphia,  and  one 
of  the  foremost  enterprises  in  its  field,  which  was  obliged 
to  sell  its  paper  on  an  eight  per  cent  basis.  Individual  bond 
buyers,  large  merchants  and  manufacturers  who  are,  to  an 
increasing  extent,  investing  a  portion  of  their  profits  in 
negotiable  securities,  had  their  funds  so  fully  employed  in 
their  business  that  no  surplus  remained  for  investment.  Rail- 
road and  industrial  corporations  were  at  this  time  heavily 
committed  to  new  undertakings.  To  obtain  the  money  for 
these  extensions  and  improvements,  rather  than  burden  them- 
selves with  high  rates  of  interest  during  the  life  of  long 
term  bonds,  they  preferred  to  sell  short  time  notes,  generally 
J  paying  six  per  cent  interest,  which  would  be  taken  by  banks 
and  private  investors  on  account  of  the  security  offered  and 
the  high  rates  of  interest  approximating  those  which  could  be 
obtained  in  the  loan  market.  The  amount  of  notes  put  out 
by  the  principal  railroads  and  industrial  corporations  during 
this  year  was  $136,000,000.  The  corporations  making  these 
issues  preferred  to  pay  higher  rates  for  one,  two,  or  three 
3^ears  in  the  belief  that  when  the  date  of  maturity  arrived,  the 
condition  of  the  bond  market  would  have  so  much  improved 
as  to  permit  the  retirement  of  these  short  term  obligations 
with  bonds  at  lower  rates  of  interest. 

An  illustration  of  the  use  of  short  term  obligations  was  the 
$15,000,000  of  six  per  cent  gold  notes  issued  by  the  Southern 
Railway  on  May  1,  1908.  The  bond  market  at  this  time  was 
so  greatly  depressed  that  none  but  issues  of  the  strongest  cor- 
porations would  be  taken.    The  Southern  Railway  was  not  in 


THE   ISSUE   OF   EVIDENCES    OF   DEBT       301 

this  class.  Its  credit  was  considered  so  doubtful  that  it 
was  not  expedient  to  attempt  to  market  its  bonds.  These  notes 
were  offered  at  98 J  and  accrued  interest  and  were  payable  on 
or  before  May  1,  1911. 

Short  term  notes  may  be  either  secured  or  unsecured.  If 
unsecured,  their  value  rests  upon  the  general  credit  of  the 
company  which  depends  primarily  upon  its  surplus  earnings 
over  charges.  The  security  of  notes  is  also  increased  by  the 
fact  that,  in  most  cases,  their  proceeds  are  invested  in  the  im- 
provement of  the  property.  For  example,  in  the  case  of  the 
Southern  Eailway  notes,  it  was  proposed  to  apply  the  proceeds 
of  the  notes  substantially  as  follows : 

"  First,  to  provide  capital  for  obligations  accrued  and  to 
accrue,  representing  generally  the  retirement  of  equipment 
obligations,  the  purchase  of  steel  rails,  construction  now 
under  contract,  and  additional  betterments  and  improve- 
ments to  the  properties  covered  by  the  development  and  gen- 
eral mortgage,  say  $8,500,000;  to  provide  for  the  redemp- 
tion of  the  sterling  notes  which  will  mature  on  June  1st  and 
July  2d  next,  say  $3,000,000.  The  balance  to  be  used  to  re- 
imburse the  treasury  to  that  extent  for  moneys  heretofore  ex- 
pended for  construction  and  capital  account,  say  $3,500,000." 

Oiit  of  $15,000,000  of  notes,  the  proceeds  of  $8,500,000 
would  go  to  improvements  which  might  reasonably  be  sup- 
posed to  produce  revenue  equal  to  the  interest  on  the  notes, 
and  which  increased,  to  that  extent,  the  value  of  the  property 
which  secured  the  notes.  Only  $3,000,000  were  provided  to 
fund  other  notes.  Short  term  notes  are  better  secured  when 
the  proceeds  of  the  sale  are  to  be  spent  for  the  benefit  of  the 
company  than  when  they  merely  take  the  place  of  other  ma- 
turing obligations.  The  sale  of  these  notes  for  refunding  pur- 
poses is  much  more  difficult  than  when  at  least  the  major  por- 
tion of  their  proceeds  is  to  be  spent  upon  the  property. 

Short  term  notes  are  usually  secured.  In  cases  where  they 
have  been  issued  on  account  of  the  present  unsalability  at 
attractive  prices  of  mortgage  bonds  already  authorized,  it  is 
customary  to  pledge  collateral  as  additional  security  for  the 


302  COKPOEATION   FINANCE 

notes.  The  $15,000,000  of  Southern  Eailway  notes,  for  ex- 
ample, were  secured  by  $20,000,000  of  Southern  Eailway 
development  and  general  mortgage  four  per  cent  bonds. 
Series  "A,''  by  $2,500,000  of  Tennessee  Central  Eailroad 
prior  lien  mortgage  four  per  cent  bonds,  and  by  $2,000,000 
Virginia  &  Southwestern  Eailway  first  consolidated  mortgage 
five  per  cent  bonds.  Earlier  in  1908,  the  Hudson  Company, 
of  New  York  City,  sold  $15,000,000  of  six  per  cent  notes, 
secured  by  the  deposit  of  $22,500,000  of  the  first  mortgage 
4J  per  cent  bonds  of  the  Hudson  &  Manhattan  Eailroad  Com- 
pany which  owns  the  tunnels  between  New  York,  Jersey  City 
and  Hoboken.  Indeed,  the  securing  of  these  short  term 
obligations  by  collateral  is  so  common  that  the  giving  of  such 
security  may  now  be  considered  obligatory.  Even  a  strong 
company  like  *the  Pennsylvania  Eailroad  Company,  or  its 
subsidiary,  the  Pennsylvania  Company,  secures  its  short  term 
obligations  by  ample  collateral. 

Since  these  notes  are  sold  on  a  banking  basis,  and  are 
secured  by  collateral,  it  is  fair  to  the  company  that  they 
should  have  the  same  liberty  of  reducing  their  loans  which 
is  allowed  to  the  ordinary  borrower  on  collateral.  This  pro- 
vision is  usually  made.  The  Hudson  Company's  notes,  for 
example,  were  issued  subject  to  the  right  of  redemption  on 
any  interest  date,  upon  thirty  days'  notice,  at  par  and  inter- 
est, plus  a  premium  of  one  per  cent  per  annum  upon  the  prin- 
cipal from  date  of  redemption  to  maturity. 

If  at  any  time  during  the  life  of  the  short  term  obligation, 
a  favorable  opportunity  arises  to  sell  the  collateral,  it  is  usual 
to  provide  that  this  can  be  done.  Thus,  in  the  issue  above  de- 
scribed it  is  provided  that : 

"  The  Southern  Eailway  is  to  have  the  right  at  any  time 
to  withdraw  by  payment  therefor  in  cash  at  the  following 
prices:  Development  and  general  mortgage  four  per  cent 
bonds.  Series  '  A,'  at  the  same  price  and  for  the  same  periods 
as  provided  above  for  the  conversion  of  the  notes;  Tennes- 
see Central  prior  lien  mortgage  four  per  cent  bonds  at  not 
less  than  85  per  cent;  Virginia  &  Southwestern  first  consoli- 


THE   ISSUE    OF   EVIDENCES    OF   DEBT       303 

dated  mortgage  five  per  cent  bonds  at  not  less  than  90  per 
cent,  with  accrued  interest  in  each  case.  Such  cash  is  to  be 
applied  by  the  trustee  to  the  purchase  or  redemption  of  the 
notes  as  provided  in  the  trust  indenture." 

The  use  of  notes  is  merely  a  temporary  expedient  to 
bridge  over  a  period  when  bonds  cannot  be  sold.  Although 
they  may  be  sometimes  funded  into  other  notes  of  the  same 
kind,  it  is  not  possible  for  this  process  to  be  continued  in- 
definitely, and  refunding  usually  requires  higher  or  better 
security  on  the  new  notes.  These  notes  must,  in  other  words, 
be  paid,  principal  and  interest,  within  a  short  time.  On  this 
account,  large  reliance  upon  this  means  of  obtaining  new 
capital  is,  for  a  weak  corporation,  considered  unsafe.  Al- 
though it  is  expected  that  the  bond  market  may  improve  to 
admit  of  the  collateral  back  of  the  notes  being  sold  at  good 
prices,  yet  this  improvement  cannot  be  guaranteed,  and  it 
has  frequently  happened  that  short  term  obligations  came 
due  at  a  time  when  it  was  most  inconvenient  for  the  company 
to  pay  them.  With  a  strong  corporation,  in  such  an  event,  no 
difficulty  is  to  be  expected,  but  if  the  maturity  of  the  notes 
coincides  with  a  period  of  business  depression,  when  the  net 
earnings  of  the  issuing  company  are  below  even  their  normal 
level,  and  when  the  bond  buyer  is  unusually  critical  concern- 
ing the  securities  offered  him,  the  company  which,  for  the 
sake  of  saving  interest,  has  burdened  itself  with  the  obliga- 
tion to  repay  a  large  sum  of  money  at  such  an  inopportune 
time,  may  run  great  danger  of  bankruptcy.  The  difficulty 
experienced  by  the  Wheeling  &  Lake  Erie,  and  the  Erie  Rail- 
road Companies  in  refunding  their  notes  maturing  in  1908, 
illustrates  the  danger  of  relying  upon  this  method  of  procur- 
ing funds.  The  first  of  these  companies  was  forced  into 
bankruptcy  by  the  maturity  of  a  note  issue,  and  the  Erie  was 
only  saved  from  a  like  fate  by  the  intervention  of  Mr.  E.  H. 
Harriman.  For  any  but  the  strongest  companies  whose  abil- 
ity to  take  care  of  maturing  obligations  is  undoubted,  the 
provision  of  new  capital  by  the  issue  of  short  term  notes  is 
to  be  entered  upon  with  great  caution. 


CHAPTER   XXIV 
LONG  TERM  BONDS 

Long  term  bonds  are  of  two  kinds — those  without  special 
security,  known  as  debentures,  and  those  with  special  security, 
such  as  mortgage  bonds,  collateral  trust  bonds,  and  car  trust 
certificates. 

A  debenture  is  a  certificate  of  debt  issued  by  a  corpora- 
tion without  mortgage  or  collateral  security.  An  illustration 
of  a  debenture  is  an  issue  by  the  New  York,  New  Haven  & 
Hartford  in  1904,  which  is,  in  substance,  as  follows : 

Fifty  years  after  date,  the  New  York,  New  Haven 
&  Hartford  Railroad  Company  promises  to  pay  .... 
or  order,  $1,000  at  the  ofiice  of  its  Treasurer,  in  the 
city  of  New  Haven,  Connecticut,  and  to  pay  interest 
thereon  from  date  at  the  rate  of  3|  per  cent  per  an- 
num. 

The  security  offered  to  the  debenture  holder  is  the  right  of 
action  against  the  company  in  default  of  their  payment  of 
principal  or  interest.  In  this  respect,  debentures  are  superior 
to  preferred  stock  which  they  resemble  in  having  a  prior 
claim  to  earnings,  a  claim,  however,  which  is  enforceable  by 
legal  action. 

The  measure  of  the  value  of  the  debenture  bonds  is  the 
surplus  earnings  of  the  corporation  over  the  prior  fixed 
charges.  They  are,  in  no  respect,  save  in  name,  different  from 
junior  mortgage  bonds,  and  they  usually  bear  a  higher  rate 
of  interest  than  first  mortgage  bonds.  Debentures  differ 
radically  from  income  bonds.  An  income  bond  is  a  bond 
304 


'     LONG   TERM   BONDS  305 

whose  interest  is  payable  if,  in  the  judgment  of  the  directors, 
it  has  been  earned^  but  whose  principal,  like  that  of  any 
other  bond,  is  payable  at  a  definite  date.  So  far  as  their 
interest  is  concerned,  therefore,  income  bonds  are  in  exactly 
the  same  position  as  preferred  stock,  and  they  are  of  inferior 
value  to  cumulative  preferred  stock  in  that  the  interest  on 
incomes  is  not  carried  over  to  accumulate  against  future  earn- 
ings. In  so  far,  however,  as  the  principal  of  income  bonds 
must  eventually  be  paid,  they  are  superior  to  preferred  stock. 
Income  bonds  have  been  but  little  used  in  recent  years.  They 
were  extensively  employed  before  1890  in  various  railway  re- 
organizations, the  Wabash  incomes  being  perhaps  the  most 
familiar  instance,  but  they  have  fallen  into  disuse  because 
they  possess  the  virtues  and  the  value  neither  of  stock  nor 
bonds. 

Returning  now  to  the  consideration  of  debentures,  we 
find  that  the  contracts  with  the  debenture  holders  may  con- 
tain certain  special  securities  which  go  far  to  compensate  for 
the  absence  of  mortgage  security.  It  may  be  provided  that 
no  mortgage  shall  be  placed  upon  the  property  unless  the 
debentures  are  included  in  the  lien  of  the  mortgage.  Thus, 
for  example,  in  the  offer  of  the  debentures  of  the  New  York, 
New  Haven  &  Hartford  appears  the  following: 

These  debentures  will  also  provide,  as  far  as  lawfully 
may  be,  that  if  this  company  shall  thereafter  create 
any  mortgage  upon  its  now  existing  main  line  of  rail- 
road between  Woodlawn  in  the  City  and  State  of 
New  York,  and  Springfield  in  the  Commonwealth  of  ^ 
Massachusetts,  or  its  now  existing  main  line  between 
New  Haven  in  the  State  of  Connecticut,  and  Provi- 
dence in  the  State  of  Rhode  Island,  such  debentures 
shall,  without  further  act,  be  entitled  to  share  in  the 
security  of  such  mortgage  pro  rata  with  any  other 
obligations  that  may  be  secured  thereby,  and  that  any 
such  mortgage  shall  expressly  so  provide. 

It  may  be  provided  that,  as  long  as  the  debentures 
are  outstanding,  the  debt  of  the  company  shall  not  be 
increased.     The  agreement  with  the  debenture  bond- 


306  COKPOKATION   FINANCE 

holders  of  the  Colorado  Fuel  &  Iron  Company  pro- 
vides that  "  so  long  as  any  of  said  debentures  or  the 
interest  warrants  annexed  thereto,  shall  be  unpaid,  no 
mortgage  or  other  encumbrance  shall  be  placed  upon 
any  of  the  property  of  the  Iron  Company,  nor  shall 
any  other  debentures  be  authorized  or  issued,  nor  any 
other  bonds,  except  those  provided  for  in  the  mortgages 
or  deeds  of  trust  outstanding  July  1,  1901,  and  except 
bonds  and  mortgages  to  be  authorized  and  issued  to  re- 
place the  bonds  provided  for  in  such  mortgages  or 
deeds  of  trust,  in  case  the  Iron  Company  may  desire  to 
refund  the  same  or  any  of  them,  but  in  no  event  shall 
the  par  value  of  its  said  refunding  bonds  exceed  the 
par  value  of  the  bonds  which  they  shall  be  issued  to 
replace,  nor  shall  the  rate  of  interest  on  any  of  such 
refunding  bonds  exceed  the  rate  of  interest  upon  the 
bonds  which  they  shall  be  issued  to  replace,  it  being  the 
meaning  of  this  agreement  that  neither  the  total 
amount  of  bonds  at  any  time  outstanding  nor  the  rate 
of  interest  thereon,  so  long  as  any  of  said  debentures 
or  the  interest  warrants  annexed  thereto  shall  be  un- 
paid, shall  be  increased;  nor  shall  any  notes  be  issued 
or  indebtedness  authorized  or  created  for  any  other 
purpose  than  the  ordinary  running  expenses  of  the 
Iron  Company. 

The  precautions  indicated  in  the  foregoing  extract  are 
highly  desirable  from  the  standpoint  of  the  debenture  bond- 
holder. 

A  corporation  which  has  issued  debenture  bonds  may  have  i'*^ 
retained  the  right  to  issue  bonds  under  its  various  mortgages,  ^ 
by  which  the  security  of  a  debenture  which  can  be  satisfied 
only  after  the  prior  claims  of  mortgage  bonds,  would  be  seri- 
ously impaired.  By  inserting  in  the  contract  with  the  de- 
benture bondholder  s\ich  a  provision  as  the  foregoing,  a  cor- 
poration, so  long  as  the  debentures  were  outstanding,  would 
be  unable  to  issue  any  other  form  of  debt  than  short  term 
notes  or  an  inferior  grade  of  debentures. 

It  may  also  be  provided  for  the  protection  of  the  de- 
benture bondholders  that  the  proceeds  of  these  bonds  shall 
be  expended  in  a  specified  manner  for  the  benefit  of  the  prop- 


LONG   TEEM   BONDS  307 

erty.     To  quote  again  from  the  agreement  of  the  Colorado 
Fuel  &  Iron  Company: 

The  Iron  Company  agrees  that  the  proceeds  of  the 
initial  $10,000,000  of  said  debentures  shall  be  used 
only  for  additions  and  improvements  to  the  plant  of 
the  company,  and  for  working  capital  and  other  cor- 
porate purposes,  and  that  the  proceeds  of  the  remain- 
ing $5,000,000  of  said  debentures  shall  be  used  only 
for  the  acquisition  of  additional  property. 

It  would  be  impossible,  in  view  of  this  clause  in  the  con- 
tract, for  the  proceeds  of  the  debentures  to  be  used  to  retire 
outstanding  indebtedness  of  the  company,  or  as  a  means  of 
providing  funds  for  the  distribution  of  a  portion  of  the 
company's  surplus  to  stockholders.  The  provision  stipulates 
that  all  the  money  which  the  purchasers  of  the  debenture 
bonds  pay  into  the  treasury  of  the  company  shall  be  expended 
in  such  a  manner  as  to  increase  the  value  of  the  company's 
property,  and  the  net  earnings  upon  which  the  debenture 
bondholders  must  rely  for  their  interest.  With  these  safe- 
guards thrown  about  him,  the  position  of  the  debenture  bond- 
holder is  not  greatly  inferior  to  that  of  the  holder  of  a 
second  mortgage  bond. 

In  order  to  make  debenture  bonds  more  attractive,  and 
to  sell  them  at  higher  prices,  many  corporations  have  adopted 
the  plan  of  making  these  bonds  convertible  into  stock  at  a 
certain  figure.  The  issue  of  debentures  with  the  convertible 
feature  is  rapidly  growing  in  favor,  and  several  of  the  strong- 
est railroads  in  the  country — the  Union  Pacific,  the  Atchison, 
and  the  New  York,  New  Haven  &  Hartford — ^have  adopted 
this  plan  of  financing  their  capital  requirements.  These  con- 
vertible debentures  are  direct  obligations  of  the  issuing  com- 
pany, although  they  are  unsecured  by  mortgage.  They  carry 
a  fixed  rate  of  interest  and  are  payable  at  a  definite  date. 
In  addition,  the  holders  of  the  bonds  are  given  the  privilege 
of  converting  them  into  stock,  usually  common  stock,  at  a 
certain  figure,  either  up  to  a  certain  date  or  after  a  certain 
date.     For  example,  the  ten-year  five  per  cent  convertible 


308  CORPORATION   FINANCE 

gold  bonds  of  the  Atchison,  Topeka  &  Santa  Fe  are  convert- 
ible into  common  stock  prior  to  June  1,  1913,  at  the  option 
of  the  holder,  on  the  basis  of  ten  shares  of  common  stock,  par 
value  100,  for  each  $1,000  bond ;  and  the  Delaware  &  Hudson 
Company,  in  1906,  issued  ten-year  debenture  four  per  cent 
convertible  bonds,  convertible  into  the  common  stock  of  the 
company  prior  to  June  15,  1912,  on  the  basis  of  five  shares 
of  stock  for  each  $1,000  bond.  The  conversion  privilege  on 
some  convertible  bonds  does  not  begin  for  a  number  of  years, 
as,  for  example,  the  six  per  cent  debenture  bonds  of  the  New 
York,  New  Haven  &  Hartford  are  convertible  between  1923 
and  1948,  at  par  into  the  common  stock  of  the  company.  As 
a  rule,  however,  the  conversion  privilege  is  immediate.  The 
conversion  price  is  usually  fixed  at  a  figure  considerably  above 
the  market  price  of  the  stock  when  the  bonds  are  issued. 

The  advantages  offered  by  these  bonds  to  the  investor 
are  evident.  Convertible  bonds,  considered  as  obligations  of 
the  company,  rank  with  junior  lien  bonds.  A  company  which 
has  a  long  dividend  record  is  reasonably  certain  to  pay  inter- 
est and  principal  of  its  junior  mortgage  bonds.  The  stock 
of  the  corporation  represents  the  residuary  claim  to  the  in- 
crease in  its  profits  and  values.  If  the  business  of  the  comr 
pany  is  well  conducted,  its  stock  may  go  to  a  high  figure. 
The  holder  of  the  convertible  bond  can  then  make  a  large 
profit  by  exchanging  his  bonds  for  stock. 

A  feature  connected  with  convertible  bonds  which  makes 
them  especially  attractive  to  the  speculative  element  always 
to  be  attentively  considered  in  any  sale  of  securities,  is  the 
movement  of  their  value  as  compared  with  the  movement 
of  stock  values.  Since  the  convertible  debenture  is  a 
bond,  an  unconditional  obligation  of  the  corporation  to  pay 
money,  it  will  be  valued  as  a  bond  by  its  holders,  and 
there  will  be  a  certain  point  below  which  it  will  not  fall. 
The  purchaser  of  five  per  cent  debenture  bonds  of  a  strong 
railroad  company  at,  say,  96,  can  be  reasonably  certain  that, 
no  matter  how  unfavorable  the  financial  situation  may  be,  the 
price  of  his  security  will  not  fall  much  below  90.    The  stock 


LONG   TERM   BONDS  309 

of  the  same  company,  although  it  may  pay  a  higher  dividend 
than  the  rate  of  interest  on  the  bond,  may  easily  fall  to  75. 
On  the  other  hand,  when  the  price  of  the  stock  advances,  the 
convertible  bonds,  since  they  are  exchangeable  for  the  stock, 
also  rise  more  rapidly  than  other  junior  lien  bonds  which  do 
not  have  the  conversion  privilege.  The  Atchison,  Topeka  & 
Santa  Fe  has  outstanding  a  large  issue  of  convertible  four 
per  cent  bonds  as  well  as  a  second  mortgage  four  per  cent 
bond,  known  as  Adjustment  Mortgage  four  per  cent.  Dur- 
ing the  panic  of  1907,  the  adjustment  mortgage  4s  fell 
to  77J  and  the  convertible  4s  to  80.  With  the  revival  of 
business,  the  stock  of  the  Atchison  rapidly  advanced,  and 
the  convertible  bonds  rose.  On  November  24,  1909,  the  con- 
vertible 4s  sold  at  119 J  while  the  adjustment  mortgage  4s 
had  only  recovered  to  94J. 

Up  to  and  beyond  the  conversion  figure,  as  long  as  any 
of  the  convertible  bonds  remain  outstanding,  the  price  of  the 
stock  and  of  the  bonds  into  which  the  stock  is  convertible 
will  move  together.  The  price  of  the  convertible  bond  will 
usually  be  lower  than  the  price  of  the  stock  for  which  it  is 
exchangeable,  since  a  large  part  of  the  demand  for  convertible 
bonds,  which  have  risen  to  high  figures  because  of  this  ex- 
change privilege,  will  come  from  investors  who  choose  this 
method  to  acquire  the  stock  at  less  than  market  figures.  Con- 
vertibles sell  at  a  lower  price  than  the  stock  for  which  they 
are  exchangeable,  for  the  same  reason  that  rights  to  subscribe 
to  stock  at  par  sell  for  smaller  sums  than  the  amounts  repre- 
sented by  the  differences  between  par  and  market  price  on 
any  given  date.  The  correspondence,  however,  between  the 
price  movements  of  convertible  bonds  and  stock  is  sufficiently 
close  to  make  these  bonds  very  attractive  to  a  large  class  of 
investors  who  are  not  averse  to  taking  a  speculative  profit  if 
this  can  be  done  with  moderate  risk. 

Convertible  bonds  are  also  bought  largely  by  speculators 

as  a  protection  against  short  sales.     Suppose,  for  example, 

a  speculator  desires  to  sell  Atchison  stock  short  around  par. 

He  begins  his  operations  by  buying  ten  of  the  convertible 

21 


310  COKPOKATION   FINANCE 

bonds  which  will  be  selling  around  96.  He  then  sells  100 
shares  of  Atchison  short,  borrows  the  stock  from  some  one 
who  has  it  to  lend,  and  deposits  his  bonds  as  the  principal 
security  for  the  loan,  receiving  $10,000  for  the  stock,  less 
his  commissions,  with  which  he  can  pay  for  his  bonds  and 
have  a  small  profit  remaining,  subject  to  the  risks  of  his 
contract  to  deliver  100  shares  of  stock  whenever  called  upon 
by  the  lender.  Suppose,  now,  that  his  calculations  are  cor- 
rect, and  that  Atchison  falls  to  90.  His  convertible  bonds 
may  decline,  although  this  is  not  necessarily  involved  in  a 
situation  which  would  produce  a  fall  in  the  price  of  the  stock. 
He  might,  however,  lose  three  points  on  his  bonds.  At  the 
same  time,  however,  he  would  make  $10  a  share  on  his  trans- 
action in  the  stock,  since  he  could  purchase  100  shares  for 
$9^000,  and  deliver  the  stock  to  the  one  from  whom  he 
borrowed  it,  receiving  back  his  convertible  bonds.  In  the 
event  of  the  speculator's  calculations  proving  erroneous,  and 
if  Atchison  stock  advanced  ten  points  to  110,  he  would  lose 
$10  a  share  on  his  stock,  or  $1,000.  His  convertible  bonds, 
however,  would  probably  advance  to  105,  so  that  his  net  loss 
would  be  only  $100.  Furthermore,  in  the  unlikely  event  of 
the  stock  being  cornered,  the  holder  of  convertible  debentures 
can  protect  himself  by  exchanging  his  bonds  for  stock  which 
the  company  holds  in  its  treasury  available  for  the  conversion 
from  the  date  the  bonds  are  issued.  Owing  in  part  to  these 
speculative  advantages  possessed  by  convertible  debenture 
bonds,  they  are  in  large  demand,  and  their  prices  are  often 
far  above  their  investment  values. 

Whatever  may  be  said  of  the  debenture  bond  from  the 
standpoint  of  the  investor — and  it  must  be  admitted  that  the 
position  of  most  debenture  bondholders  as  unsecured  cred- 
itors is,  from  an  investor's  standpoint,  not  especially  attrac- 
tive— there  can  be  no  cfuestion  that  they  offer  to  a  corporation 
whose  stock  is  selling  so  close  to  par  that  it  cannot  count  on 
disposing  any  large  amount  at  that  figure,  and  which  is  not 
in  a  position  to  issue  first  mortgage  bonds,  an  opportunity 
to  obtain  money  on  favorable  terms  by  combining  the  doubt- 


LONG   TEEM   BONDS  311 

ful  investment  quality  of  debentures  with  the  speculative  pos- 
sibilities involved  in  the  conversion  privilege.  From  the  com- 
pany's standpoint,  the  sale  of  convertible  debentures  is  merely 
a  deferred  sale  of  the  stock  for  which  the  convertibles  are 
to  be  exchanged.  This  deferred  sale  of  stock  is  often  made, 
through  conversion,  at  a  high  premium,  a  much  higher 
premium  than  could  be  obtained  by  selling  the  stock  direct. 
The  use  of  convertible  debentures  has  been  criticised  on  the 
ground  that  a  company  by  resorting  to  this  form  of  security 
will  spoil  the  market  for  its  prior  lien  bonds.  As  a  rule,  how- 
ever, debentures  are  not  resorted  to  as  long  as  first-class  bonds 
under  prior  lien  mortgages  are  available  for  sale. 


CHAPTER   XXV 
MORTGAGE  BONDS 

We  next  take  up  long  term  obligations  with  mortgage,  col- 
lateral, or  lease  security.  American  financiers  are  committed 
to  the  idea  of  specific  security.  Until  recent  years,  it  has 
been  very  difficult  to  sell  debenture  bonds  at  values  com- 
mensurate with  their  real  security.  Laws  regulating  the 
investment  of  the  funds  of  savings  banks  and  trust  funds 
usually  stipulate  first  mortgage  bonds.  In  Great  Britain,  on 
the  other  hand,  mortgage  bonds  are  rare ;  there  the  debenture 
is  the  usual  form  of  security. 

Recognizing  the  preference  of  the  American  investor  ifiw 
mortgage  bonds,  corporation  directors,  in  formulating  a  plan 
for  provision  of  new  capital,  must  keep  in  view,  in  selecting 
a  type  of  obligation,  the  following  objects:  First,  they  must 
secure  for  the  corporation  the  money  required;  second,  they 
must  procure  this  money  at  a  reasonable  cost;  third,  they 
should  provide,  if  possible,  in  a  mortgage  whose  bonds  are 
readily  taken  by  investors,  for  subsequent  issues  of  bonds. 
The  directors  come  next  to  the  consideration  that  the  in- 
vestor will  pay  a  higher  price  for  first  mortgage  bonds  than 
for  any  junior  security.  Of  two  bonds  of  equal  security,  so 
far  as  earnings  are  concerned,  one  secured  by  a  first  and  the 
other  by  a  second  mortgage  on  the  same  property,  the  first 
mortgage  bond  will  always  be  preferred.  This  preference 
is  easily  explained.  In  case  of  bankruptcy  and  reorganiza- 
tion, the  first  mortgage  bonds  are  in  a  position  of  great  ad- 
vantage. Up  to  the  earning  power  of  the  property  set  aside 
to  secure  them,  they  must  be  protected.  Before  the  holder  of 
312 


MORTGAGE    BONDS  313 

second  mortgage  bonds  can  enforce  the  lien  of  their  security, 
they  must  satisfy  all  the  claims  of  the  first  mortgage.  The 
investor's  first  concern  is  the  safety  of  his  principal.  He 
wishes  the  utmost  protection.  This  protection  the  first  mort- 
gage, as  distinct  from  any  junior  lien,  gives  him.^ 

Next  in  order  to  first  mortgage  bonds,  in  grading  secured 
issues,  the  investor  will  rank  collateral  trust  bonds  where  the 
security  consists  of  other  bonds  or  dividend-paying  stock,  and 
where  the  borrowing  company  can  pay  the  interest,  if  need 
be,  without  depending  upon  the  income  produced  by  the  col- 
lateral. Finally,  he  will  put  bonds  secured  by  leases,  such 
as  car  trust  certificates.  Two  problems  then  confront  the 
directors  of  corporations  proposing  to  issue  bonds.  They 
must  give  the  bonds,  if  possible,  the  security  of  a  first  mort- 
gage, and,  if  this  cannot  be  done,  they  must  adopt  some  form 
of  obligation  which  will  give  the  bonds  issued  a  first  lien  on 
either  securities  owned  or  on  rights  under  leases.  In  case 
neither  method  is  available,  and  also  as  additional  security 
in  all  cases,  the  corporation  may  assume  the  indirect  or  con- 
ditional obligation  of  a  guarantor  or  indorser  of  bonds  which 
are  sold  for  its  benefit. 

In  giving  bonds  first  mortgage  security,  it  is  necessary 
to  deal  with  two  types  of  existing  mortgages.  First,  those 
which  stipulate  that  all  property  subsequently  acquired  by 
the  corporation  shall  come  under  the  existing  mortgages,  and 
second,  those  which  set  aside  specific  property  as  security, 
leaving  subsequently  acquired  property  to  be  pledged  as  se- 
curity for  additional  loans.    Under  the  first  classification  we 

^  Many  exceptions  can  be  cited  to  this  rule.  Some  of  the  best 
bonds  are  secured  by  general  mortgages — that  is,  second  and  third 
mortgages.  The  Erie  prior  lien  bonds,  for  example,  are  secured  by 
a  sixth  mortgage  on  its  main  line.  In  these  cases,  however,  the  first 
mortgages  are  usually  for  small  amounts  calling  for  such  moderate 
payments  in  relation  to  the  surplus  earnings  of  the  company  that 
the  investor  disregards  the  prior  liens.  A  tendency  is  visible,  however, 
in  recent  years,  among  railroad  financiers,  to  retire,  as  far  as  possible, 
these  underlying  liens  in  order  to  bring  the  mortgages  securing  the 
large  issues  of  general  mortgage  bonds  nearer  the  property. 


314  COKPOKATION   FINANCE 

find  two  types  of  mortgages — the  open-end  mortgage,  and  the 
closed  mortgage.  Under  the  open-end  mortgage  bonds  may 
either  be  issued  to  any  amount  without  limit,  or  a  bond  reserve 
large  enough  to  provide  for  all  future  needs  of  the  company 
is  authorized,^  the  bonds  being  protected,  however,  by  the 
requirement  that  the  money  shall  be  invested  in. a  specified 
way  for  the  benefit  of  the  company,  or  that  their  issue  shall 
be  controlled  and  approved  by  some  disinterested  authority. 
Bonds  are  issued  under  a  closed  mortgage  when  the 
amount  of  bonds  to  be  issued  under  the  mortgage  is  limited. 
Closed  mortgages  are  of  two  kinds:  First,  where  the  property 
subsequently  acquired  by  the  corporation  is  included  under 
the  lien  of  the  mortgage;  and  second,  where  the  lien  is  lim- 
ited to  the  property  enumerated  in  the  instrument.  The 
first  may  be  called  an  inclusive  and  the  second  an  exclusive 
closed  mortgage.  Closed  mortgages  have  the  following  form 
of  enumeration  of  property  transferred : 

Together  with  all  the  branches,  extensions  and  sid- 
ings thereof  and  therefrom,  and  all  the  lands  and 
rights  of  way  used  and  occupied,  or  surveyed,  laid  out, 
or  intended  to  be  used  and  occupied  for  the  said  rail- 
roads, branches,  extensions  and  sidings,  with  all  the 
railroad  tracks,  buildings  and  improvements  thereon, 
and  all  and  singular  the  lands,  bridges,  trestle  works, 
wharves,  shops,  stations,  depots,  engine  houses,  en- 
gines, cars,  rolling  stock,  furniture,  equipments,  and 
generally  all  and  singular  the  estate,  real  and  per- 
sonal, of  the  said  .  .  .  Kailway  Company,  whatsoever 
and  wheresoever^  now  owned  or  hereafter  to  he  ac- 
quired hy  it^ 

An  illustration  of  the  exclusive  closed  mortgage  where 
the  'lien  of  the  mortgage  is  limited  to  specified  property, 
and  does  not  include  any  property  which  may  be  hereafter 
acquired,  is  furnished  by  the  mortgage  securing  the  first  lien 

^  The  true  open-end  mortgage  is  rare.  For  practical  purposes  a 
bond  reserve  several  times  the  amount  of  the  initial  issue  is  equivalent 
to  the  authorization  of  unlimited  issue. 

*  Italics  are  the  author's. 


MORTGAGE   BONDS  315 

convertible  four  per  cent  gold  bonds  of  the  Union  Pacific 
Eailroad  Company,  due  May  1,  1911,  which  assigns  to  the 
trustee : 

All  and  singular  the  several  lines  of  railroad,  prop- 
erty, and  premises  belonging  to  the  Railroad  Com- 
pany which  are  particularly  described  as  follows.  .  .  . 
Together  with  all  additions,  lands,  terminals,  yards, 
bridges,  tracks,  rights  of  way,  trackage  rights,  build- 
ings, telegraphs,  shops,  elevators,  and  other  structures 
and  fixtures,  easements  and  leaseholds,  corporate  rights 
and  franchises,  now  held  or  acquired  or  hereafter  held 
or  acquired  for  use  in  connection  with  the  said  lines 
of  railroad,  specifically  above  described;  and  also  the 
earnings  and  profits  thereof,  also  the  following  de- 
scribed bonds  and  stocks,  namely:  .  .  .  Together  with 
any  and  all  shares  of  stock  or  bonds  of  any  other  cor- 
poration which  the  Railroad  Company  may  hereafter 
deposit  and  pledge  hereunder  by  way  of  substitution 
or  otherwise/ 

Under  this  mortgage,  the  security  of  the  bonds  is  specific- 
ally restricted  to  the  property  enumerated  in  the  mortgage, 
and  there  is  no  obligation  on  the  part  of  the  company,  al- 
though it  may  do  so,  if  it  desires,  to  add  to  this  security. 

First  mortgage  bonds  can  be  issued  under  inclusive  closed 
mortgages  only  if  a  portion  of  the  bonds  authorized  has  been 
reserved  to  provide  for  the  future  needs  of  the  company.  Un- 
der most  of  the  closed  mortgages  issued  by  the  large  railroad 
companies,  only  small  amounts  can  still  be  issued.  For  ex- 
ample, the  offering  by  the  Guarantee  Trust  Company  of 
$2,072,000  prior  lien  3J  per  cent  gold  bonds  of  the  Baltimore 
&  Ohio  Railroad  Company  in  July,  1908,  contained  the  fol- 
lowing : 

With  the  above  offering  the  mortgage  is  closed,  and 
in  consequence  this  is  probably  the  last  opportunity 
to  obtain  a  round  amount  of  these  bonds  at  a  satis- 
factory price.     The  general  inability  of  the  railroads 

1  Italics  are  the  author's. 


316  COKPOKATION   FINANCE 

to  create  in  the  future  new  bonds  which  will  compare 
in  point  of  security  with  first  mortgages  of  this  class 
renders  this  an  opportunity  which  should  be  em- 
braced. 

If  the  authorization  of  bonds  under  a  closed  first  mortgage 
has  been  exhausted  by  issue,  the  only  recourse  of  the  directors 
desiring  to  give  to  the  investor  bonds  secured  by  a  prior  lien, 
is  to  the  issue  of  bonds  by  a  subsidiary  company  organized 
for  that  purpose,  and  guaranteed  by  the  parent  company; 
or  to  a  collateral  trust  issue,  if  the  first  mortgage  of  the 
parent  company  does  not  include  all  securities  owned  in  its 
schedule  of  property  "  to  be  hereafter  acquired  " ;  or  to  a 
combination  of  the  two  methods.  These  methods  of  raising 
capital  we  shall  take  up  in  detail  in  their  proper  places.  If 
the  closed  mortgage  does  not  include  "  all  property  to  be 
hereafter  acquired,"  so  that  the  company  can  subject  some 
of  its  property  to  the  lien  of  a  first  mortgage,  then  it  is  usual 
to  execute  a  general  refunding  first  mortgage,  or  a  con- 
solidated first  mortgage  which  will  become  a  first  mortgage 
on  all  the  property  of  the  company  when  the  underlying 
bonds  mature.  Provision  is  made  for  a  sufficient  issue  of 
bonds  under  the  consolidated  mortgage  to  retire  the  prior 
lien  bonds,  and  the  general  effect  and  impression  is  that  of 
a  first  mortgage  bond.  Eef erring  again  for  illustration  to 
the  issue  of  bonds  by  the  Union  Pacific  above  noted,  we  find 
the  following  description  of  the  security  in  a  letter  from 
President  E.  H.  Harriman,  under  date  of  June  8,  1908 : 

"  Eef  erring  to  the  '  first  lien  and  refunding  mortgage  four 
per  cent  bonds '  of  this  company,  I  beg  to  state  that  these 
bonds  are  to  be  secured  by  a  first  mortgage  on  1,177.71  miles 
main  track  and  146.63  miles  other  track  of  owned  railroad 
lines.  The  lines  mortgaged  are  valuable  and  important  parts 
of  this  company's  system.  .  .  .  The  amount  of  bonds  which 
may  be  issued  at  present  on  the  security  above  stated  is  $50,- 
000,000,  and  no  further  amount  can  be  issued  in  addition 
thereto  until  the  security  of  the  mortgage  be  extended  to  cover 


MORTGAGE   BONDS  3I7 

(subject  only  to  the  first  mortgage  of  this  company,  dated 
July  1,  1897)  all  the  lines  covered  by  said  first  mortgage  .  .  . 
the  entire  railroad  mileage  of.  the  Union  Pacific  Railroad 
Company.  When  the  lien  of  this  mortgage  is  extended  to  cover 
all  of  the  present  railroad  mileage  of  the  Union  Pacific  Rail- 
road Company,  the  total  authorized  amount  of  bonds  which 
may  be  issued  thereunder,  including  the  above  $50,000,000, 
will  be  $200,000,000,  of  which  $100,000,000  are  to  be  reserved 
to  refund  the  first  mortgage  four  per  cent  bonds,  due  July 
1,  1947,  for  a  like  face  amount,  which  first  mortgage  bonds 
shall  not  be  extended  when  due,  so  that  the  'first  lien  and 
refunding  mortgage  shall  ultimately  become  the  sole  first 
mortgage  upon  the  entire  present  railroad  property  of  the 
company,  and  upon  any  additional  property  hereafter  ac- 
quired or  constructed  with  the  proceeds  of  bonds  of  this 
issue/  ^  The  remaining  $50,000,000  bonds  are  to  be  reserved 
to  be  issued  only  for  the  construction  or  acquisition  of  addi- 
tional lines  of  railroad,  connecting  with  the  lines  then  sub- 
ject to  the  mortgage,  and  for  the  acquisition  of  other  property 
for  use  on  or  in  connection  with  the  mortgaged  lines  and 
for  improvements  thereon,  as  specified  in  the  mortgage,  and 
all  of  which  shall  then  pass  under  the  lien  securing  the  en- 
tire issue  of  these  bonds." 

The  Union  Pacific,  it  appears  from  this  statement,  took 
advantage  of  the  fact  that  its  first  mortgage  is  not  inclusive 
of  all  property  which  it  may  hereafter  acquire,  to  pledge 
certain  lines  which  had  been  built  or  purchased  since  the 
first  mortgage  was  executed,  under  the  lien  of  this  first  con- 
solidated mortgage.  This  is,  therefore,  a  first  mortgage  on 
some  lines,  and  a  second  mortgage  on  others.  It  is  also  here 
provided,  which  is  usual  in  this  type  of  security,  that  eventu- 
ally this  first  and  refunding  mortgage  shall  become  an  abso- 
lute first  mortgage  on  all  the  property  of  the  system. 

Here  again  we  find  the  precaution  taken  that  the  com- 
pany should  have  available  first  mortgage  bonds,  in  the  pro- 

*  The  italics  are  the  author's. 


318  CORPOKATION   FINANCE 

vision  that  $50,000,000  are  to  be  reserved  for  subsequent 
issue.  Great  care  is  taken  in  drawing  refunding  mortgages 
to  provide  that  the  maturing  bonds  should  be  retired,  either 
by  payment  or  conversion,  as  fast  as  they  mature,  so  that  the 
priority  of  the  lien  of  the  refunding  mortgage  shall  be  ex- 
tended as  rapidly  as  possible. 

Bonds  are  not  often  issued  under  second  and  third  mort- 
gages except  in  reorganizations.  So  strong  is  the  prejudice 
against  them,  that  even  here  they  have  fallen  into  disuse. 
There  are  exceptions  to  this  rule,  but,  generally  speaking, 
second  mortgage  bonds  cannot  be  sold  to  advantage. 

CORPORATE   INDORSEMENTS   AND   GUARANTEES 

When  first  mortgage  bonds  cannot  be  sold,  resort  may 
be  had  to  several  methods  of  securing  the  obligations  with 
which  the  desired  capital  is  to  be  obtained.  The  purpose  of 
each  of  these  methods  is  to  approximate  as  closely  as  possible 
the  security  of  a  first  mortgage.  The  first  of  these  methods 
is  to  organize  subsidiary  companies  in  the  interest  of  the 
company  which  desires  to  provide  the  new  capital.  These 
companies  issue  to  the  parent  company  their  bonds  secured 
by  a  first  lien  on  the  property  purchased  or  constructed,  and 
also  secured  by  the  indorsement  of  the  parent  company.  The 
parent  company  can  either  sell  the  subsidiary  company's 
bonds  direct,  or  can  deposit  them  as  collateral  security  for 
an  issue  of  its  debentures,  unless  compelled  by  the  terms  of 
its  prior  lien  mortgages  to  deliver  them  to  the  trustees  of  its 
existing  obligations.  A  large  amount  of  railway  mileage  has 
been  built  in  this  manner  through  subsidiary  companies, 
either  because  the  parent  company  was  limited  in  its  borrow- 
ing by  the  terms  of  its  mortgages,  or  because  the  laws  of  the 
State  where  the  new  lines  were  located  required  ownership  by 
a  local  company.  This  form  of  financing  new  construction 
is  not  so  common  as  formerly. 

The  use  of  the  indorsement  is  still  general.  One  of  the 
most  common  uses  of  this  method  in  recent  years  is  the  in- 


MOETGAGE   BONDS  319 

dorsement  of  bonds  of  terminal  companies  by  the  various  rail- 
way corporations  which  make  use  of  the  facilities  thus  pro- 
vided. A  number  of  issues  of  bonds  have  been  made  by  new  or 
weak  companies  in  recent  years  secured  by  the  indorsement 
of  certain  prominent  and  wealthy  individuals  or  firms.  The 
most  conspicuous  illustration  of  this  use  of  individual  credit 
to  bolster  up  the  credit  of  weak  companies  was  furnished 
by  Mr.  H.  H.  Rogers  in  his  guarantee  of  the  bonds  of  the 
Virginian  Railway,  and  by  Mr.  Henry  M.  Flagler,  on  the 
strength  of  whose  personal  guarantee  a  large  amount  of 
notes  were  sold  by  the  Florida  &  East  Coast  Railway  Com- 
pany. Another  use  of  the  guarantee  is  the  sale  of  equip- 
ment notes  given  to  such  companies  as  the  American  Loco- 
motive Company  or  the  American  Car  &  Foundry  Company 
by  weak  railway  companies,  and  which  are  sold  with  the 
indorsement  of  the  equipment  companies. 

An  indorsement  of  a  corporate  bond  has,  of  course,  the 
same  form  and  significance  as  an  indorsement  on  a  promis- 
sory note.  By  indorsing  a  note,  a  person  or  corporation  alike 
agree  that  in  case  the  maker  does  not  pay  the  note  at  matu- 
rity the  indorser  will  pay  it.  Corporate  guarantees  are  of 
two  kinds:  First,  strong  guarantees,  and  secorfd,  weak  guar- 
antees.   An  example  of  a  weak  guarantee  is  as  follows : 

For  value  received  the  Great  Western  Power  Co. 
hereby  guarantees  to  the  holder  of  the  within  bond 
the  prompt  and  punctual  payment,  according  to  the 
terms  thereof,  of  the  principal  of,  and  interest  upon, 
the  within  bond,  and  further  guarantees  to  the  said 
holder  that  the  sinking  fund  installments  in  respect 
to  Series  "  A "  bonds  provided  in  the  mortgage  and 
deed  of  trust  and  in  said  bond  referred  to  shall  he 
made  in  ^  the  manner  and  to  the  extent  therein  pro- 
vided. 

•  This  guarantee  is  weak  in  the  sense  that  it  merely  stipu- 
lates that  the  holders  of  the  bonds  of  the  California  Electric 
Generating  Company  to  which  the  guarantee  referred,  will 

» Italics  are  the  author's. 


320  COKPOKATION   FINANCE 

receive  their  interest  and  principal  and  will  be  protected  in 
accordance  with  the  terms  of  the  mortgage.  The  Great 
Western  .Power  Company  does  not  itself  formally  assume 
the  obligation,  but  merely  agrees  to  assume  it  in  case  the 
California  Electric  Generating  Company,  which  issues  the 
bonds,  fails  to  carry  out  its  agreement.  An  example  of  a 
strong  guarantee  is  as  follows :  "- 

For  value  received  the  St.  Louis  Southwestern  Kail- 
way  Company  hereby  unconditionally  guarantees  to 
the  owner  of  the  within  bond  the  payment  of  the 
principal  thereof  and  the  interest  thereon  as  the  same 
matures  and  falls  due,  and  hereby  agrees  itself  to 
pay  the  said  principal  and  interest  if  default  in  the 
payment  thereof  be  made  by  the  Terminal  Company. 

Here  is  an  unconditional  assumption  of  debt  by  the  guar- 
antor, and  this  form  is  preferred  to  that  first  given.  An  even 
stronger  form  is  the  following  guarantee  indorsed  upon  bonds 
of  the  New  York  &  Westchester  Lighting  Company,  a  sub- 
sidiary of  the  Consolidated  Gas  Company  of  New  York : 

For  value  received,  the  Consolidated  Gas  Co.  of 
New  York  hereby  assumes  and  agrees  to  pay  the  prin- 
cipal and  interest  of  the  within  bond  as  the  same  shall 
respectively  become  payable. 

Here  is  the  strongest  form  of  guarantee,  the  assumption  by 
the  guarantor  of  the  obligation  of  paying  interest  and  prin- 
cipal, assuming  itself  the  risk  of  reimbursement  from  the 
treasury  of  the  subsidiary  company.  Another  form  of  guar- 
antee provides  that  the  guarantor  shall  deposit  within  a  cer- 
tain time  before  each  interest  date,  with  the  trustee  of  the 
bonds,  the  amount  required  for  the  payment  of  that  install- 
ment of  interest.  As  a  rule,  the  guarantee  is  preferred  in 
proportion  as  the  guarantor  assumes  an  unconditional  obliga- 
tion under  his  indorsement.  Another  common  form  of  guar- 
anteed security  is  stock  on  which  a  certain  rate  of  dividend 
has  been  guaranteed  by  another  company.  This  method  is 
mainly  employed  in  connection  with  leases. 


MORTGAGE   BONDS  321 

The  remedy  of  the  holders  of  guaranteed  bonds  or  stock 
is  the  same  as  the  remedy  of  the  holder  of  an  indorsed  note, 
namely,  a  suit  against  the  indorser  for  the  amount  remain- 
ing unpaid.  The  objections  to  this  form  of  security  are, 
therefore,  the  ordinary  objections  to  indorsement  security, 
namely,  the  necessity  of  suing  the  indorser,  unless  it  is  to 
his  interest  to  protect  his  obligations,  and  the  fact  that  there 
may  be  no  limit  to  the  amount  of  contingent  liability  which 
may  be  assumed.  In  case  of  strong  companies,  which  have 
guaranteed  bonds  secured  by  mortgages  on  integral  portions 
of  their  system,  covering  property  which  is  essential  to  their 
business,  guarantees  are  regarded  as  of  great  value.  Such 
bonds  are  often  sold  on  no  other  security  than  the  indorse- 
ment, no  attention  being  paid  to  the  earnings  of  the  com- 
pany actually  issuing  the  bonds. 

The  second  objection  to  the  guarantee  as  compared  with 
the  mortgage  security,  is  more  serious.  When  bonds  are  is- 
sued, secured  by  a  mortgage,  certain  property  is  conveyed 
to  the  trustee.  The  purchaser  of  the  bonds  knows  that  when 
the  issue  authorized  by  that  mortgage  has  been  exhausted, 
no  further  bonds  can  be  issued  on  the  security  of  that  prop- 
erty, unless  they  follow  the  first  mortgage  bonds.  The  whole 
transaction  is  a  matter  of  record.  The  creditor  knows  ex- 
actly what  the  value  of  the  security  is.  On  the  other  hand, 
a  company  with  a  surplus  of  $1,000,000  over  interest  charges 
may  place  its  indorsement  on  a  series  of  bonds  issued  by  other 
companies  whose  stock  it  has  acquired.  These  guarantees, 
if  the  borrowing  companies  do  not  prosper,  may  steadily 
shrink  in  value,  as  the  margin  between  the  amount  which  the 
guarantor  may  be  obliged  to  pay  under  its  indorsement,  and 
its  surplus  income  from  the  stocks  of  its  subsidiaries,  is  re- 
duced. The  company  with  a  surplus  of  $1,000,000  may 
assume  the  contingent  liability  of  a  guarantor  up  to  $100,000 
a  year,  and  the  bonds  will  be  good  aside  from  the  earning 
power  of  the  property  which  directly  secures  them.  When, 
however,  these  guarantees  aggregate  $600,000  or  $700,000  a 
year,  the  investor  must  look  more  closely  into  the  condition 


322  COEPOKATION   FINANCE 

of  the  borrowing  companies,  and  must  place  correspondingly 
less  reliance  upon  the  security  offered  by  the  indorsement. 
There  are  some  companies,  such  as  the  American  Water 
Works  Company,  which  have  indorsed  enormous  amounts  of 
bonds,  and  which  are  continually  offering  additional  issues 
with  the  argument  that  they  are  also  secured  by  indorsement. 
So  far  as  the  value  of  the  guarantee  extends,  however,  it  is 
a  question  whether  this  unlimited  indorsement  is  not  a  source 
of  weakness  rather  than  strength. 

This  objection  to  the  security  of  a  guarantee  can  be  easily 
met,  however,  by  including  in  the  indorsement  an  obligation 
of  the  guarantor  to  limit  his  contingent  liability.  If,  for 
example,  his  surplus  earnings  are  $500,000  a  year  and  he 
assumes  a  contingent  liability  to  pay  $250,000,  it  may  be 
provided  in  the  indorsement  that  no  additional  guarantees 
will  be  assumed  by  the  indorser  until  the  surplus  earnings 
have  reached  $1,000,000.  By  preserving  a  safe  margin  be- 
tween the  payments  which  may  be  required  by  the  contingent 
liability,  and  the  surplus  earnings  out  of  which  these  pay- 
ments must  be  made,  the  security  of  a  guarantee  may  closely 
approach  the  security  of  a  mortgage. 


CHAPTER   XXYI 
THE  COLLATERAL  TRUST  BOND 

The  method  of  financing  new  construction  by  the  sale 
of  bonds  of  subsidiary  companies  guaranteed  by  the  parent 
company  is  advantageous  only  for  strong  corporations. 
Small  issues  of  subsidiary  company  bonds  with  the  addi- 
tional security  of  a  guarantee,  when  the  guarantor  is  not 
abundantly  able  to  meet  all  these  contingent  obligations  with- 
out calling  upon  the  issuer  of  the  guaranteed  securities,  are 
not  popular.  One  of  the  main  reasons  for  issuing  first  and 
refunding  or  first  and  general  lien  bonds  is  to  offer  the  in- 
vestor a  large  issue  and  a  direct  obligation.  It  is  increas- 
ingly difficult  to  sell  the  bonds  issued  by  small  companies. 

When  it  is  impossible  or  inexpedient  for  a  company  to  is- 
sue first  mortgage  bonds,  and  unless  it  is  of  the  first  rank, 
so  that  its  guarantee  carries  conviction,  its  best  method  of 
obtaining  new  funds  is  to  issue  its  own  debenture  bonds 
secured  by  the  deposit  of  stocks  and  bonds  of  subsidiary  com- 
panies to  which  it  makes  advances  for  construction  pur- 
poses. These  bonds  have  already  been  described  as  collateral 
trust  bonds.  The  value  and  the  salability  of  these  bonds 
depends  not  so  much  upon  the  earnings  of  the  subsidiary 
company  whose  securities  are  pledged,  as  upon  the  solvency 
of  the  company  which  issues  the  obligation.  It  is  not  usual 
to  issue  collateral  trust  bonds  secured  only  by  the  stocks  and 
bonds  of  a  single  company.  A  number  of  issues  of  subsidiary 
companies  are  usually  combined  to  furnish  security  for  a 
large  issue  of  the  parent  company's  bonds. 

One  of  the  first  cases  where  this  method  was  employed 


324  CORPORATION   FINANCE 

was  by  the  Union  Pacific  in  1879.  In  1873,  in  order  to  pro- 
tect the  second  mortgage  lien  of  the  government  to  secure 
these  advances  in  aid  of  construction,  a  law  was  passed  pro- 
hibiting the  Union  Pacific  from  increasing  its  bonded  debt. 
Any  additional  property  which  it  might  acquire  must  come 
under  the  lien  of  this  second  mortgage.  As  a  result,  the 
Union  Pacific  could  build  no  branch  lines  nor  extensions. 
It  was  necessary  to  build  this  additional  mileage  through 
subsidiary  companies.  The  Union  Pacific  advanced  the 
money  for  construction  out  of  its  current  earnings,  receiv- 
ing the  capital  stock  and  first  mortgage  seven  per  cent  bonds 
of  the  construction  companies.  To  reimburse  its  treasury 
for  these  advances,  the  Union  Pacific  pledged  these  first 
mortgage  bonds  as  collateral  security  for  an  issue  of  $7,- 
000,000  of  six  per  cent  bonds.^  In  1882,  a  second  collateral 
trust  issue  was  made  by  the  Union  Pacific  for  a  similar  pur- 
pose. Other  railway  companies  which  have  made  large  use 
of  the  collateral  trust  bond  in  aid  of  construction  are  the 
Missouri  Pacific,  the  Eock  Island,  and  the  Louisville  & 
Nashville.  A  collateral  trust  bond  secured  by  a  lien  upon 
the  first  mortgage  bonds  of  subsidiary  companies  gives 
greater  security  than  the  contingent  liability  of  a  guarantee, 
since  it  is  a  direct  obligation  of  the  parent  company.  It  is, 
however,  inferior  to  the  lien  of  a  first  mortgage,  since  a 
foreclosure  of  the  collateral  trust  mortgage  places  the  cred- 
itor- in  possession  of  other  bonds,  which  necessitates  addi- 
tional foreclosure  proceedings  before  he  can  get  at  the  prop- 
erty which  is  the  object  of  his  search. 

Collateral  trust  mortgages  contain  a  number  of  safe- 
guards designed  to  preserve  the  value  of  the  collateral. 
When  the  security  consists  of  bonds,  it  is  stipulated  that 
no  more  bonds  of  equal  rank  shall  be  issued  by  the  subsidiary 
company,  even  though  the  subsidiary  company's  mortgage 
authorizes  additional  issues.  To  this  end,  the  company 
owning   the    stock   of  the   subsidiary   company   is   required 

^  Thomas  Warner  Mitchell  in  the  Quarterly  Journal  of  Economics, 
vol.  XX,  1905-06,  p.  443. 


THE   COLLATERAL   TRUST   BOND  325 

to  deposit  this  stock,  or  a  controlling  interest  therein,  with 
the  trustee  to  make  sure  that  the  directors  of  the  sub- 
sidiary company  will  not  exercise  their  right  to  increase  the 
issues  of  the  bonds,  and  so  weaken  the  value  of  the  collateral 
trust  bonds.  When  the  bonds  of  a  parent  company  are  is- 
sued to  obtain  funds  for  making  advances  to  subsidiary  com- 
panies in  aid  of  construction,  it  is  important  to  stipulate 
that  the  parent  company  shall  secure  from  the  subsidiary 
companies  evidences  of  their  indebtedness  in  the  form  of 
bonds  secured  by  mortgages,  and  that  these  bonds  shall  be  at 
once  pledged  with  the  trustee  of  the  collateral  trust  mort- 
gage. 

Greater  care  is  taken  in  the  framing  of  collateral  trust 
indentures  to  protect  the  value  of  stock  collateral  than  is 
necessary  in  case  of  bond  collateral.  The  trust  indenture 
securing  the  Northern  Pacific-Great  Northern-Chicago,  Bur- 
lington &  Quincy  Collateral-Trust  Bonds,  contains  a  num- 
ber of  precautions  of  this  character.  The  railway  companies 
which  acquired  by  the  issue  of  these  bonds  about  ninety-eight 
per  cent  of  the  stock  of  the  Burlington,  agree  with  the  trus- 
tee that,  in  case  there  shall  be  issued  any  additional  shares  of 
the  Burlington  stocky  except  only  treasury  stock  reserved 
for  bond  conversion,  then  the  railway  companies  will  assign 
to  the  trustee  ninety-eight  per  cent  of  such  additional  capital 
stock.  They  bind  themselves  not  to  distribute  any  part  of 
the  surplus  of  the  Burlington  existing  on  July  1,  1901,  since 
such  a  distribution  would  weaken  the  value  of  the  stock.  They 
agree  also  that  they  will  cause  all  necessary  repairs,  renewals, 
and  replacements  to  be  made  out  of  the  earnings  of  the  Bur- 
lington lines;  that  they  will  not  permit  the  execution  by  the 
Burlington  of  any  lease  of  any  of  the  railways  in  its  system 
unless  such  lease  shall  be  made  subject  to  termination  by  the 
Burliiigton,  if  the  shares  of  the  stock  held  by  the  trustee  shall 
be  sold  in  case  of  any  default;  and  finally  that  they  will  not 
permit  the  sale  of  any  part  of  the  property  of  the  Burlington, 
unless  ninety-eight  per  cent  of  the  proceeds  of  the  sale  is  de- 
posited with  the  trustee  as  security  for  the  bonds. 


326  COKPORATION   FINANCE 

Collateral  trust  bonds  differ  from  call  loans  with  col- 
lateral security  in  that  they  usually  contain  no  provision  for 
the  substitution  of  collateral.  We  have  seen  that  mortgages 
securing  bonds  by  liens  on  real  property  allow  directors,  with 
the  consent  of  the  trustee,  to  sell  any  part  of  the  property 
for  which  they  have  no  further  use,  provided  only  that  the 
proceeds  of  this  sale  be  reinvested  in  place  of  the  property 
withdrawn.  The  security  of  stock  or  bond  collateral  is,  how- 
ever, by  no  means  so  substantial  as  that  furnished  by  the 
pledge  of  real  property.  Especially  when  the  bonds  run  for 
a  long  term,  the  substitution  of  other  collateral  for  that  origi- 
nally deposited  is  usually  considered  to  give  too  much  latitude 
to  the  borrowing  company. 

It  is,  however,  possible  to  include  the  privilege  of  sub- 
stituting collateral  under  adequate  safeguards.  An  illustra- 
tion of  this  method  is  furnished  by  the  mortgage  securing 
the  four  per  cent  refunding  twenty-five-year  gold  bonds  of 
the  Oregon  Short  Line  Railroad  Company  dated  December 
1,  1904.  These  bonds  were  secured  by  the  capital  stock  of  the 
Northern  Securities  Company,  the  Southern  Pacific  Company, 
and  the  Oregon  Railroad  and  Navigation  Company.  Article 
6  of  the  indenture  allows  withdrawal  of  the  pledged  securities 
and  the  substitution  of  collateral.  Withdrawal  may  be  made 
up  to  eighty  per  cent  of  the  value  of  these  securities  ascer- 
tained by  appraisement  at  the  time  of  their  delivery  to  the 
trustee.  Section  2  authorizes  the  substitution  of  the  stocks  of 
securities  of  railroad,  steamship,  or  terminal  companies  for 
collateral  placed  under  the  mortgage  to  a  value  equal  to  the 
value  of  the  securities  withdrawn.  The  method  of  appraise- 
ment is  for  two  appraisers  to  be  appointed  representing  the 
railroad  company  and  the  trustee,  respectively,  and  for  these 
appraisers  to  choose  a  third  whose  judgment  as  to  the  value 
of  collateral  is  to  be  final. 

The  collateral  trust  bond  is  employed  for  a  variety  of 
purposes  in  addition  to  the  financing  of  construction  by  sub- 
sidiary companies.  A  company  whose  only  property  con- 
sists of  the  stocks  and  bonds  of  other  companies  is  usually 


THE  COLLATERAL  TRUST  BOND     327 

limited  to  the  collateral  trust  bond.  The  bonds  issued  by  the 
large  industrial  corporations  organized  in  the  form  of  hold- 
ing companies,  whose  chief  assets  consist  of  the  stocks  of 
a  number  of  subsidiaries,  furnish  numerous  illustrations 
of  this  method.  In  such  indentures,  either  the  stocks  of 
subsidiary  companies  can  be  pledged  under  the  mortgage, 
or  the  subsidiary  companies  themselves,  in  return  for  funds 
advanced  to  them  by  the  parent  company,  can  execute  their 
own  mortgage  bonds,  and  turn  these  over  to  the  parent  com- 
pany to  be  deposited  under  the  collateral  trust  indenture. 
The  precaution  usually  taken  is  to  have  all  the  securities, 
both  stocks  and  bonds,  of  the  subsidiary  companies  de- 
posited under  the  indenture,  and  to  provide  in  the  mort- 
gage that  the  parent  company,  in  return  for  any  advances 
which  it  may  make  to  the  subsidiary  companies  out  of  the 
proceeds  of  the  collateral  trust  bonds,  shall  obtain  from  the 
subsidiary  companies,  and  shall  deliver  to  the  trustee  suit- 
able evidences  of  indebtedness  to  furnish  additional  security 
under  the  collateral  trust  mortgage.  Should  default  occur, 
the  holder  of  the  collateral  trust  bonds  comes  into  the  posses- 
sion of  bonds  or  notes  of  the  subsidiary  companies  secured  by 
direct  liens  on  their  property. 

The  collateral  trust  bond  is  also  employed  by  corporations 
to  acquire  the  stock  of  some  other  company  which,  when 
pledged  as  security  for  an  issue  of  collateral  trust  bonds, 
furnishes  the  means  for  its  own  purchase  without  seriously 
taxing  the  credit  of  the  purchasing  company.  Collateral 
trust  bonds  are,  as  already  explained,  plain  obligations  of 
the  issuing  company.  They  are  promissory  notes  which, 
when  issued  by  a  solvent  corporation,  have  a  value  apart 
from  any  special  security  which  may  be  deposited.  In  or- 
der to  give  them  greater  currency  and  value,  however,  the 
stock  of  a  company  which  has  been  purchased  may  be  de- 
posited as  collateral  security,  in  this  manner  providing  the 
funds  for  its  own  purchase.  Familiar  examples  of  this  use 
of  the  collateral  trust  bond  are  furnished  by  the  Great  North- 
ern-Northern Pacific,  Burlington  Joint  4s  already  referred 


328  COKPOEATION   FINANCE 

to;  also  by  the  issue  of  collateral  trust  three  and  a  half  per 
cent  bonds  by  the  New  York  Central,  in  1897  to  purchase  the 
stock  of  the  Lake  Shore  &  Michigan  Southern,  and  Michigan 
Central  Eailroad  Companies. 

In  each  of  these  cases,  the  stock  security  placed  under 
the  collateral  trust  bonds  of  the  purchasing  company  has 
produced  a  revenue  at  least  equal  to  the  interest  on  the 
bonds,  so  that  the  income  accounts  of  the  parent  companies 
have  not  been  drawn  upon,  save  temporarily,  to  pay  interest 
on  the  collateral  trust  bonds.  The  credit  of  the  parent  com- 
pany is,  therefore,  kept  intact  for  the  issue  of  other  deben- 
tures for  other  purposes.  With  bonds  amply  secured  by  stock 
collateral,  the  investor  does  not  consider  the  obligation  as  a 
burden  upon  the  finances  of  the  parent  company.  At  the 
same  time,  however,  the  surplus  earnings  of  the  parent  com- 
pany stand  back  of  the  bonds  to  reassure  any  holder  who 
may  be  uncertain  of  the  value  of  the  collateral  security.  For 
example,  the  Great  Northern-Northern  Pacific,  Burling- 
ton Joint  4s  have  an  interest  charge  of  $8,000,000.  The 
Burlington  pays  each  year  $8,000,000  in  dividends,  and 
earns  far  more  than  this  amount,  producing  a  consider- 
able surplus  over  all  interest  charges.  Besides  this,  how- 
ever, the  two  purchasing  companies  had  surplus  earnings  in 
their  last  fiscal  year  over  their  fixed  charges  amounting  to 
$37,800,000,  nearly  five  times  the  interest  charges  on  the 
joint  4s. 

When  collateral  trust  bonds  are  issued  by  companies 
whose  principal  assets  consist  of  the  securities  pledged  under 
the  lien  of  the  collateral  trust  indenture,  then  the  investor 
looks  mainly  to  the  value  of  the  collateral,  and  the  price  of 
the  bond  fluctuates  with  the  fortunes  of  the  company  whose 
stock  furnishes  its  sole  security.  An  illustration  of  a  bond 
with  no  other  security  than  stock  is  furnished  by  the  col- 
lateral trust  4s  issued  by  the  Chicago,  Rock  Island,  Pacific 
Railroad  Company  of  Iowa,  a  company  whose  sole  assets 
consist  of  the  stock  of  the  Chicago,  Rock  Island,  Pacific  Rail- 
way  Company  of  Iowa.    During  1909,  the  price  of  the  bonds 


THE   COLLATEKAL   TKUST   BOND  329 

showed  an  extreme  fluctuation  of  nine  and  one  half  per  cent. 
The  bonds  are  highly  speculative,  since  their  interest  must 
come  solely  from  the  dividends  paid  by  the  Chicago,  Kock 
Island  and  Pacific  Kailw;a^  Company.  During  the  same  year, 
however,  the  Burlington  Joint  48,  whose  interest  absorbs 
a  much  greater  proportion  of  the  dividends  on  the  Burling- 
ton stock  than  that  proportion  of  the  Rock  Island  Railway 
dividends  which  is  required  to  pay  interest  on  the  collateral 
trust  bonds  which  its  stock  secures,  fluctuated  only  four 
per  cent.  The  smaller  fluctuations  of  the  Burlington  Joint 
4s  as  compared  with  the  Rock  Island  bonds  show  the  high 
standing  which  collateral  trust  bonds  issued  by  strong  com- 
panies possess.  At  the  same  time,  as  already  shown,  unless 
the  company  issuing  the  collateral  trust  bonds  secured  by 
dividend-paying  stock  is  obliged  to  make  up  the  difference 
between  the  interest  on  the  bonds  and  the  dividends  on  the 
stock  securing  them,  its  credit  is  not  seriously  weakened  by 
the  issue  of  collateral  trust  bonds. 

When  such  advances  have  to  be  made,  however,  as  for 
a  time  was  necessary  in  the  case  of  the  Atlantic  Coast  Line 
— Louisville  &  Nashville  collateral  5s — the  attention  of 
the  investor  is  directed  to  the  nature  of  the  collateral  trust 
bonds,  the  direct  obligation  of  the  issuing  company,  alto- 
gether apart  from  the  stock  security  underlying  it.  The 
existence  of  collateral  trust  bonds  in  such  an  event  operates 
to  subtract  from  the  borrowing  power  of  the  issuing  com- 
pany, perhaps  more  than  might  be  expected  from  the  extent 
of  this  deficit  between  the  dividends  on  the  collateral  stock 
and  the  interest  on  the  bonds.  The  liability  of  the  issuing 
company  is  then  regarded  in  much  the  same  light  as  the  con- 
tingent liability  of  a  guarantee  when  the  borrowing  company 
is  not  earning  its  interest  and  must  call  upon  the  indorser  of 
its  bonds  to  make  up  the  deficit. 


CHAPTER    XXVII 
BONDS  SECURED  BY  THE  ASSIGNMENT  OF  A  LEASE 

Another  method  of  securing  capital  in  the  face  of  a 
closed  first  mortgage  is  by  the  use  of  the  lease  as  security. 
The  detailed  discussion  of  the  lease  is  postponed  to  a  later 
chapter.  At  this  point  it  is  sufBcient  to  define  the  lease  as 
a  contract  by  which  the  possession  of  property  is  transferred 
by  the  owner,  known  as  the  lessor,  to  some  other  person  or 
corporation,  known  as  the  lessee,  the  title  of  the  property  re- 
maining in  the  lessor  but  the  lessee  being  allowed  its  pos- 
session and  use  under  certain  conditions  set  down  in  the 
lease. 

The  lease  is  largely  used  by  railroad  companies  to  borrow 
money  for  the  purchase  of  equipment  under  a  form  of  obli- 
gation, known  as  the  car  trust  certificate,  by  which  the  prop- 
erty acquired  serves  as  the  security  for  the  bonds,  and  which 
are  also  the  direct  obligations  of  the  railroad  company.  This 
method  of  borrowing  may  be  illustrated  by  the  issue  of  the 
Lehigh  Valley  Car  Trust  Certificates,  Series  G.  A  syndicate, 
headed  by  E.  T.  Stotesbury,  a  leading  Philadelphia  banker, 
was  organized  to  purchase  and  pay  for  a  large  number  of  pas- 
senger and  freight  cars.  E.  T.  Stotesbury  then  executed  an 
agreement  whereby,  in  return  ier  certain  payments,  and  on 
the  basis  of  certain  covenants  and  stipulations,  he  leased  to  the 
railroad  company  from  October  25,  1902,  to  August  1,  1910, 
the  equipment  which  he  had  purchased,  and  which  is  carefully 
enumerated  and  described.  The  Lehigh  Valley  Railroad 
Company,  for  its  part,  in  return  for  being  allowed  the  use  of 
the  cars,  agreed  to  pay  $203,398.80  before  the  equipment  was 
330 


BONDS  SECUEED  BY  ASSIGNMENT  OF  LEASE  331 

delivered  to  them  and  half  yearly  the  following  sums:  First, 
a  sum  equal  to  2^  per  cent  on  $800,000  to  be  reduced  from 
time  to  time  by  2^  per  cent  on  money  paid  by  the  railroad 
company  in  reduction  of  $800,000.  Second,  a  sum  equal  to 
all  expenses  incurred  by  the  lessor  in  enforcing  the  covenants 
and  terms  of  the  lease.  Third,  a  sum  equal  to  the  taxes 
which  the  lessor  might  be  liable  to  pay.  Fourth,  yearly  the 
sum  of  $100,000,  making  in  all  eight  annual  payments  of 
$100,000  each. 

The  deferred  payments  were  evidenced  by  equipment 
notes  the  substance  of  which  is  as  follows: 

The  Lehigh  Valley  Railroad  Company  hereby  ac- 
knowledges itself  to  be  indebted  to  the  bearer,  or  regis- 
tered owner  hereof,  in  the  sum  of  $1,000  with  inter- 
est at  the  rate  of  4^  per  cent  per  annum.  This  cer- 
tificate is  one  of  a  series  of  800  for  $1,000  each  issued 
under  the  terms  of  a  lease  bearing  date  of  the  25th 
day  of  October,  1902,  between  E.  T.  Stotesbury  and 
the  Lehigh  Valley  Railroad  Company.^ 

In  addition  to  these  payments,  the  railroad  company 
agrees  with  the  lessor  to  keep  the  cars  in  good  repair,  to  re- 
place any  which  may  be  destroyed  from  any  cause,  to  mark 
the  name  of  the  owner  plainly  upon  the  cars,  and  to  furnish 
him  each  year  a  list  of  the  equipment,  not  to  sublet  the 
equipment,  and,  in  case  of  default  under  any  of  the  provi- 
sions of  the  lease,  to  deliver  to  the  lessor  the  equipment  to 
which  the  lease  relates.  The  lessor  on  his  part  agrees  that 
after  the  payments  have  been  completed,  he  will  upon  the 
payment  by  the  railroad  company  of  the  additional  sum  of 
one  dollar,  transfer  to  the  railroad  company,  as  its  absolute 
property,  all  the  railroad  cars  held  under  the  lease.  The 
rental  referred  to  in  this  agreement  consists  of  three  parts: 
First,  a  sum  of  cash  which  is  usually  considered  to  repre- 
sent the  expenses  and  profits  of  the  sjrndicate  acquiring  the 
equipment;   second,   a   sum   which'  represents  the   purchase 

*  Only  the  essential  portions  of  the  Car  Trust  Certificate  are  given. 


332  COEPOKATION  FINANCE 

price  of  the  equipment  payable  in  installments;  and  third, 
interest  on  the  unpaid  installments  of  the  purchase  price. 
E.  T.  Stotesbury,  having  now  purchased  the  equipment, 
and  having  leased  it  to  the  Lehigh  Valley,  assigns  the  agree- 
ment as  security  for  the  certificates  evidencing  the  deferred 
payments  under  the  lease,  to  the  Girard  Trust  Company  sub- 
stantially as  follows: 

First,  that  the  said  E.  T.  Stotesbury  hereby  assigns 
unto  the  Girard  Trust  Company  as  trustee  for  the 
holders  of  the  certificates  hereinafter  set  forth,  all  the 
right,  title  and  interest  of  said  E.  T.  Stotesbury  in 
and  to  a  certain  indenture  of  lease  bearing  even  date 
herewith  made  by  the  said  E.  T.  Stotesbury  to  the 
Lehigh  Valley  Railroad  Company. 

Second,  the  said  trustee  covenants  and  agrees  that 
it  will  certify  and  deliver  to  Drexel  &  Company 
(Jor  whom  Stotesbury  is  actingY  for  distribution  to  the 
several  subscribers  to  the  said  Lehigh  Valley  Car 
Trust  Fund  eight  hundred  certificates  in  the  following 
form  {given  above) ^  which  certificates  shall  be  de- 
livered in  amounts  and  at  times  corresponding  to  the 
value  and  the  time  of  delivery  of  the  various  lots  of 
said  railroad  cars  by  the  said  E.  T.  Stotesbury  to  the 
Lehigh  Valley  Railroad  Company.  All  of  which  cer- 
tificates, when  and  as  issued,  shall  be  entitled  to  the 
security  of  all  such  railroad  cars  previously  and  sub- 
sequently delivered  by  said  Edward  T.  Stotesbury  to 
the  Railroad  Company  under  the  terms  of  said  in- 
denture of  lease  of  even  date  herewith. 

These  certificates  were  numbered  consecutively  from  one 
to  eight  hundred  and  were  payable  in  eight  installments  be- 
ginning August  1,  1903. 
j/       The   agreement   for   assignment  of  lease,   to  which  the 
I  Lehigh  Valley  Railroad  Company  is  made  a  party,  provides 
/i/in  detail  for  the  protection  of  the  holders  of  these  certificates 
f/  by  the  trustee.    In  case  of  any  default  in  the  pajonents  under 
the  lease,  or  the  breach  of  any  other  covenant  by  the  railroad 

*  Italics  are  the  author's. 


BONDS  SECURED  BY  ASSIGNMENT  OF  LEASE  333 

company,  the  trustee  is  authorized  to  retake  possession  of  the 
cars,  and  to  hold,  or  lease,  or  to  otherwise  dis{X)se  of  all  or 
any  part  of  the  equipment  in  such  manner  as  it  may  deem 
beneficial,  and  also  to  recover  from  the  company,  for  future 
accruing  rent,  any  deficit  which  may  remain  after  the  sale 
or  lease  of  the  equipment,  and  the  application  of  the  proceeds 
to  the  claims  of  the  certificate  holders. 

From  the   foregoing,  the  strong  position  of  equipment 
trust  obligations  is  evident.     They  are,  in  fact,  debenture | 
bonds  of  the  railroad,  with  the  additional  security  of  a  firsti 
mortgage  upon  railway  equipment.     They  have  the  further' 
advantage,  explained  in  a  former  chapter  in  connection  with 
the  discussion  of  serial  bonds — that  their  margin  of  security 
constantly  increases,  since  the  equipment  is  in  existence  at 
the  time  the  last  bond  matures.     Equipment  trust  obliga- 
tions usually  bear  higher  rates  of  interest  than  first  mort- 
gage bonds  issued  for  long  terms.     They  also  yield  higher 
returns  to  the  investor  than  first  mortgage  bonds,  while  the 
security  which  they  offer  is  practically  perfect. 

The  Guarantee  Trust  Company  of  New  York,  in  a  cir- 
cular dealing  with  the  advantages  of  the  equipment  trust 
securities,  summarizes  these  advantages  as  follows: 

"The  equipment  of  a  railroad  corporation  is  essential  to 
its  operation.  It  is  the  tool  with  which  the  railroad  handles 
its  business.  If  an  individual  mechanic  becomes  bankrupt, 
his  tools  are  ordinarily  exempt  from  seizure  on  the  ground 
that  possession  of  the  tools  is  necessary  for  the  mechanic  to 
obtain  his  livelihood  and  ultimately  satisfy  his  creditors.  In 
the  same  way  the  courts,  both  State  and  Federal,  have  ruled 
that  the  necessary  equipment  of  a  railroad  must  be  preserved 
for  the  Receiver  of  a  bankrupt  railroad  in  order  to  enable 
him  to  operate  the  railroad;  and  have  generally  placed  the 
charges  of  principal  and  interest  of  equipment  obligations 
upon  an  equality  with  charges  for  wages,  materials  and  other 
operating  expenses,  and  in  priority  to  interest  of  even  first 
mortgage  bonds." 


334  COKPOKATION   FINANCE 

The  record  of  equipment  obligations  issued  by  railroad 
companies  which  have  subsequently  gone  into  bankruptcy 
confirms  this  favorable  judgment.  Without  exception  the 
principal  and  interest  on  equipment  bonds  have  been  paid  in 
full  even  by  companies  where  all  other  bonds  were  reduced 
in  interest  or  principal.  This  strong  position  of  equipment 
bonds  in  bankruptcy  is  due  to  the  fact  that  their  security  is 
not  the  property  of  the  bankrupt  corporation.  The  cars  and 
locomotives  which  they  represent  are  the  property  of  another 
who  has  leased  his  equipment  to  the  railroad  company  on  cer- 
tain definite  conditions.  Unless  these  conditions  are  met,  the 
equipment  can  be  hauled  off  the  company's  lines  and  sold. 
Property  which  is  owned  by  the  company  can,  as  we  shall  see 
in  a  later  chapter,  be  put  out  of  reach  of  creditors,  within  the 
protection  of  the  court.  The  court,  however,  can  have  no 
jurisdiction  over  property  not  belonging  to  the  bankrupt  cor- 
poration. The  receiver,  no  matter  if  he  defaults  on  the  first 
mortgage  bonds,  must  pay  the  interest  on  the  equipment  trust 
obligations. 

The  equipment  trust  bond  represents  the  most  familiar 
use  of  the  lease  as  a  means  of  obtaining  new  capital.  An- 
other method  often  employed  is  to  organize  a  subsidiary  com- 
pany in  the  interest  of  a  company  desiring  to  obtain  capital. 
This  subsidiary  company  constructs  or  purchases  the  equip- 
ment or  other  property  needed  by  the  parent  company,  issu- 
ing for  the  purpose  its  own  first  mortgage  bonds  which  may 
be  guaranteed  by  the  parent  company.  The  property  is  then 
leased  to  the  parent  company  for  a  rental  sufficient  to  pay 
the  interest  on  the  bonds  and  to  retire  their  principal  after 
a  term  of  years.  In  some  cases,  the  rental  is  made  sufficient 
to  pay  dividends  on  the  stock  of  the  subsidiary  company. 
After  the  bonds  of  the  subsidiary  company  have  been  retired, 
the  property,  upon  the  payment  of  a  nominal  sum,  passes 
to  the  parent  company.  For  the  greater  portion  of  bond- 
holders, it  is  customary  for  the  subsidiary  <5ompany,  in  such 
a  case,  to  assign  the  lease,  out  of  which  the  money  to  pay  the 
interest  on  the  bond  must  come,  to  the  trustee.    If  the  rental 


BONDS  SECUKED   BY  ASSIGNMENT  OF  LEASE  335 

is  not  paid,  then  the  interest  cannot  be  paid,  the  bonds  are 
in  default,  and  their  holders  can  bring  foreclosure  proceed- 
ings. The  trustee  can  sue  the  lessee  company  either  upon 
its  obligation  of  guarantee,  in  case  it  has  indorsed  the  bonds 
of  the  subsidiary  company,  or  under  its  contract  of  lease. 

A  third  use  of  the  lease  as  security  is  by  the  lessee  com- 
pany. The  lease,  being  a  contract  for  the  use  of  certain 
property  on  the  payment  of  certain  stipulated  sums,  may  be 
expected  to  show  a  surplus  over  the  amount  of  the  rentals. 
This  surplus  makes  the  leasehold  interest,  the  value  of  the 
annual  profits  of  the  lessee,  a  valuable  right  which  can  be 
pledged  by  the  lessee  like  any  other  thing  of  value  as  secur- 
ity for  bonds.  This  form  of  security  was  employed  by  the 
Interborough  Company  which  pledged  its  999  year  lease  of 
the  Manhattan  Eailway  and  its  subway  lease  from  New  York 
City  as  the  main  security  of  $55,000,000  of  mortgage  bonds 
dated  November  1,  1907.  The  Interborough,  from  the  op- 
eration of  these  leased  lines,  in  1909  showed  a  large  surplus 
over  rentals,  so  that  its  leasehold  interest  represented  a  valu- 
able property,  furnishing  ample  security  for  a  bond  issue. 
It  is  unusual,  however,  to  find  leases  showing  such  large 
earnings.  While  the  leasehold  interests  are  frequently  con- 
veyed as  supplementary  security  to  trustees,  they  are  not 
often  given  a  prominent  position  as  a  basis  of  bond  issues. 


CHAPTEK   XXVIII 
CONSOLIDATION  OF  CORPORATIONS 

The  consolidation  of  corporations  offers  a  means  of  ob- 
taining new  capital  without  the  necessity  of  providing  funds 
for  construction  or  purchase.  It  also  enables  companies  to 
abolish  or  restrict  competition  and  in  this  way  to  increase 
profits.  In  1901,  the  Reading  Company  desired  to  obtain 
permanent  possession  of  sufficient  terminal  facilities  in  New 
York.  The  Central  Railroad  of  New  Jersey  possessed  -these 
facilities.  The  consolidation  of  the  two  companies  gave  the 
Reading  the  use  of  the  valuable  terminals  of  the  Central 
Railroad  of  New  Jersey  in  perpetuity.  Numerous  illustra- 
tions of  the  advantages  of  consolidation  in  restricting  compe- 
tition are  furnished  by  the  industrial  trusts.  These  advan- 
tages have  been  fully  discussed  in  a  preceding  chapter. 

The  methods  of  uniting  corporations  by  consolidation  are 
three:  First,  the  merger;  second,  the  purchase  by  one  com- 
pany of  a  controlling  stock  interest  in  another;  third,  the 
lease. 

When  a  merger  of  corporations  is  accomplished,  one  or 
more  of  the  companies  concerned  loses  its  identity  in  an- 
other. Suppose  the  case  of  two  gas  companies — A  and  B — 
competing  for  the  business  of  the  same  town.  A  sufficient 
amount  of  the  stock  of  B  has  been  required  in  the  interest 
of  A,  to  control  the  sale  of  its  assets  and  its  dissolution. 
Two  methods  are  available  for  merging  B  with  A.  A  may 
offer  its  stock  or  bonds  or  cash  in  exchange  for  the  stock  of 
B,  having  acquired  the  amount  of  stock  which  by  the  laws  of 
the  state  or  the  charter  of  B  is  necessary  to  assent  to  the 


CONSOLIDATION   OF   CORPORATIONS        337 

disposition  of  B's  assets.  The  directors  of  B  now  sell  the 
property  of  that  company  to  A.  If  all  the  stock  of  B  has  been 
acquired,  the  consideration  need  be  only  nominal.  A  now  con- 
trols all  the  stock  of  B,  and  secures  the  dissolution  of  B,  in 
the  manner  provided  by  law.  The  second  method  is  for  A  to 
purchase  the  property  of  B,  at  its  market  value  in  securities 
or  cash.  B  has  then  in  its  treasury  the  proceeds  of  the  sale. 
B  is  then  dissolved  and  the  directors  distribute  its  assets  to 
its  stockholders. 

The  method  of  merger  is  seldom  adopted.  There  is  usu- 
ally some  advantage  to  a  company  acquiring  control  of  an- 
other company,  in  continuing  the  corporate  existence  of  its 
subsidiary.  Companies  which  have  been  in  existence  a  suf- 
ficient length  of  time  to  establish  a  reputation  have  a  certain 
good-will  value  in  connection  with  their  name  which  would 
terminate  if  their  corporate  existence  were  ended.  Valuable 
privileges  may  also  be  lost  if  the  method  of  merger  is  adopted. 
For  example,  the  Boston  Consolidated  Gas  Company,  where 
the  price  of  gas  is  fixed  by  law  at  eighty  cents  per  thou- 
sand feet,  owns  stock  of  the  Quincy  Gas  Light  Company, 
the  Chelsea  Gas  Light  Company,  and  the  East  Boston  Gas 
Light  Company.  In  Chelsea  and  East  Boston,  where  the 
population  is  not  so  dense  as  in  Boston,  the  legal  price  of  gas 
is  $1  per  thousand  feet.  In  Boston  the  cost  of  distributing 
gas  is  less  and  the  profit  even  at  the  lower  price  is  greater. 
If  the  large  lighting  companies  were  merged  with  the  con- 
solidated company,  the  eighty  cent  rate  would  apply  through- 
out the  consolidated  property.  It  is  desirable,  therefore,  to 
maintain  the  corporate  existence  of  these  outside  companies 
in  order  to  secure  the  $1  rate  in  the  suburbs.  In  consolida- 
tions of  street  railway  companies  possessing  perpetual  fran- 
chises, care  is  taken  to  preserve  the  corporate  existence  of  the 
companies  owning  these  valuable  franchises.^  There  is  no 
serious  disadvantage  in  maintaining  separate  existences  for 
corporations  controlled  by  other  companies.     The  salary  ac- 

'  Lecture  by  F.  E.  Snow  to  Harvard  School  of  Business  Administrar 
tion,  Jan.  15,  1909. 


338  COKPOKATION  FINANCE 

counts  of  the  subsidiary  companies  are  nominal  and  the  opera- 
tion of  their  property  can  be  merged  if  desired  by  leasing  their 
property  to  the  main  system,  or  by  operating  them  as  divisions 
or  departments  of  the  parent  company. 

The  second  method  of  consolidation  is  that  of  stock  own- 
ership. One  operating  company  can  purchase  the  stock  of 
another,  giving  in  exchange  cash  or  securities,  or  a  company 
can  be  organized  for  the  purpose  of  holding  the  stocks  of  other 
companies  which  by  this  device  are  brought  under  central- 
ized control.  How  much  stock  is  it  necessary  for  a  company 
to  acquire  to  control  another?  The  rule  of  law  is  that,  in 
the  absence  of  a  provision  allowing  stockholders  to  accumu- 
late their  votes  on  one  or  two  directors,  thus  insuring  to  the 
minority  representation  on  the  board,  a  bare  majority  of  the 
stock  can  elect,  if  the  owners  wish,  all  the  directors.  While  the 
rights  of  the  majority  are  seldom  pushed  to  this  extreme, 
yet  the  holders  of  a  majority  of  the  stock  always  demand, 
with  propriety,  a  substantial  majority  of  the  board  of  di- 
rectors. There  is  no  general  reason,  therefore,  for  acquiring 
ing  all  the  stock  of  a  corporation  in  order  to  control  it. 

Where  the  interest  of  the  parent  company  may  be  op- 
posed to  the  interest  of  the  subsidiary  company,  there  is  no 
alternative,  if  it  is  desired  to  maintain  the  identity  of  the 
subsidiary,  save  for  the  parent  company  to  acquire  all  of  its 
stock,  or  to  see  that  its  control  is  held  in  the  parent  com- 
pany's interest.  Many  of  the  consolidations  of  manufactur- 
ing concerns  have  resulted  in  the  closing  of  badly  located 
or  otherwise  unprofitable  mills  in  order  to  concentrate  the 
production  in  plants  which  are  better  equipped  or  more 
favorably  situated.  This  policy  makes  for  the  interest  of 
the  parent  company.  It  is,  however,  directly  opposed  to  the 
interests  of  minority  stockholders  of  the  corporations  owning 
the  plants  whose  operation  is  discontinued.  If  their  business 
were  to  be  closed  up  in  this  manner,  the  minority  stockhold- 
ers would  undoubtedly  appeal  to  the  courts  which  would  give 
them  effective  protection  against  the  depreciation  in  the 
value  of  their  shares  which  would  follow  the  suspension  of 


CONSOLIDATION   OF   CORPOKATIONS        339 

dividends  on  their  stocks.  To  avoid  trouble  of  this  character, 
it  is  usual  to  secure  all  the  stock  of  the  company  to  be  con- 
solidated, in  case  this  can  be  purchased  at  reasonable  figures. 

If  all  the  stock  cannot  be  acquired,  and  in  case  the 
subsidiary  company  is  to  be  exploited  for  the  benefit  of  the 
interests  which  control  it,  the  method  which  has  been  em- 
ployed in  some  cases  is  to  guarantee  a  dividend  on  the 
minority  stock  of  the  subsidiary.  This  plan  was  followed 
by  the  Carnegie  Steel  Company  in  1901  in  guaranteeing  four 
per  cent  on  the  minority  stock  of  the  Pittsburg,  Bessemer 
&  Lake  Erie  Railroad  Company,  whose  principal  freight, 
since  its  organization  in  1897,  had  been  ore  destined  for 
the  Carnegie  furnaces.  The  minority  stockholders  of  the  rail- 
road company  complained  that  their  failure  to  receive  divi- 
dends was  due  to  the  fact  that  the  owners  of  the  majority  of 
their  stock  of  the  Carnegie  Steel  Company  received  such  low 
rates  on  its  ore  that  the  railroad  company  was  unable  to  make 
a  profit.  In  order  to  quiet  this  criticism,  the  Carnegie  Steel 
Company,  through  a  subsidiary  company,  the  Bessemer  and 
Lake  Erie,  guaranteed  a  dividend  on  the  stock,  leaving  itself 
free  to  fix  rates  as  low  as  it  thought  best. 

An  exception  to  the  rule  that  all  the  stock  of  a  company, 
control  of  which  is  desired  by  another  company,  should  be 
acquired,  is  furnished  by  large  public  corporations,  such  as 
railroad  companies,  where  the  object  of  the  consolidation  is 
merely  to  secure  uniformity  in  rates  or  to  arrange  inter- 
changes of  traffic  which  will  be  mutually  profitable.  Here 
there  is  no  temptation  to  the  exploitation  of  one  company  by 
another,  and  the  minority  stockholders  have  no  reason  to  feel 
aggrieved.  Where  the  stock  of  a  company  is  widely  scattered, 
moreover,  a  controlling  interest  may  be  much  less  than  a 
majority.  The  Pennsylvania  Railroad  Company  for  seven 
years  exercised  a  potent  influence  in  the  directorates  of  the 
Baltimore  &  Ohio,  the  Chesapeake  &  Ohio,  and  the  Norfolk 
&  Western.  At  no  time,  however,  did  it  own  a  majority  of 
the  stock  of  any  of  these  companies.  Any  contest  for  con- 
trol, however,  during  the  period  of  the  Pennsylvania's  in- 


340  COEPOKATION   FINANCE 

fluence,  would  have  been  hopeless,  owing  to  the  control  of 
the  administrative  machinery  of  these  companies  in  the  inter- 
est of  their  principal  stockholder,  and  to  the  advantage  which 
this  control  would  have  been  given  these  officers  in  soliciting 
voting  proxies. 

Having  settled  upon  the  amount  of  stock  required  for 
control,  our  next  question  concerns  the  method  by  which 
this  stock  can  be  acquired.  Stock  may  be  purchased  for 
cash,  or  with  the  stock  or  bonds  of  the  purchasing  company, 
or  with  stock  trust  certificates  on  which  dividends  are  guar- 
anteed by  the  company  acquiring  the  stock.  The  considera- 
tion which  will  be  offered  and  accepted  in  the  acquisition 
of  a  stock  control  can  be  viewed  from  the  standpoint  of  the 
purchasing  company,  and  also  from  the  standpoint  of  the 
individual  stockholder.  A  purchasing  company,  if  its  surplus 
over  its  regular  disbursements  is  substantial,  can  safely  offer 
bonds  or  their  cash  equivalent  to  holders  of  stock  which  it 
desires  to  purchase.  Other  things  being  equal,  an  offer  of 
bonds  is  desirable.  If  there  is  no  identical  interest  repre- 
sented in  both  companies  to  be  considered,  if  the  purchaser 
is  in  a  strong  financial  position,  and  especially  if  there  is 
a  prospect  that  the  stock  purchased  will  become  much  more 
valuable  in  the  hands  of  the  purchaser,  the  method  of  pur- 
chase by  bonds  is  likely  to  be  adopted.  The  stockholders 
who  receive  bonds  for  their  holdings  surrender  all  right  to 
future  participation  in  the  profits  of  their  company  over  the 
amount  guaranteed  on  their  bonds.  The  purchasing  com- 
pany, by  giving  them  a  secured  claim,  succeeds  to  their 
right  to  the  increase  in  profits  over  the  amount  paid  in  in- 
terest. 

In  some  cases  these  purchases  of  stock  with  bonds  have 
proven  immensely  profitable.  In  1898  the  New  York  Central 
purchased  $45,000,000  out  of  $50,000,000  of  .the  capital  stock 
of  the  Lake  Shore,  Michigan  &  Southern,  giving  in  exchange 
its  3|  per  cent  bonds  at  the  rate  of  $200  in  bonds  for  $100 
in  stock.  The  seven  per  cent  dividends  on  the  Lake  Shore 
stock  represented  the  equivalent  of  the  interest  paid  on  the 


CONSOLIDATION   OF   COKPOKATIONS        341 

bonds  issued  in  payment.  From  1899  to  1903,  the  Lake 
Shore  paid  seven  per  cent,  from  1904  to  1906  inclusive,  eight 
per  cent,  in  1907  twelve  per  cent,  in  1908  fourteen  per  cent, 
and  in  1909  twelve  per  cent.  The  purchase  of  the  Lake 
Shore  stock  has  proven  most  fortunate  for  the  New  York 
Central.  Indeed,  had  it  not  been  for'  the  large  profits  made 
on  this  purchase,  the  Central  would  have  had  much  difficulty 
in  maintaining  its  five  per  cent  dividends  during  1909.  The 
joint  purchase  of  the  Burlington  by  the  Great  Northern  and 
the  Northern  Pacific  has  also  been  profitable,  although  the 
purchasing  companies  have  not  as  yet  taken  any  direct 
profit  into  their  income  accounts  out  of  the  large  surplus 
earnings  which  the  Burlington  is  showing  over  the  dividends 
necessary  to  pay  interest  on  the  bonds  issued  to  purchase 
this  stock.  There  is  the  more  reason  to  adopt  the  method  of 
purchasing  stock  with  the  bonds  of  the  purchaser,  if  the 
stock  desired  is  a  dividend  payer,  since  then  a  substantial 
portion  of  the  interest  on  the  bonds  can  be  provided  out 
of  the  stock  purchased. 

When  any  doubt  exists,  however,  concerning  the  ability 
of  the  purchasing  company  to  meet  the  interest  on  a  suf- 
ficient bond  issue  to  buy  the  stock  which  it  desires,  prudence 
demands  that  stock,  be  employed.  Cumulative  preferred 
stock  gives  almost  the  security  of  bonds,  with  the  added 
advantage  of  a  higher  return.  At  the  same  time,  the  failure 
to  pay  dividends  on  such  stock  does  not  work  the  bankruptcy 
of  the  company.  The  United  States  Rubber  Company  in  a 
circular  to  its  stockholders  recommending  the  purchase  of 
stock  of  the  Rubber  Goods  Manufacturing  Company,  stated 
the  argument  against  bonds  and  in  favor  of  preferred  stock 
as  follows: 

"  If  no  better  means  were  provided,  it  might  be  advisable 
to  make  such  purchase  by  the  use  of  collateral  trust  notes, 
but  it  occurred  to  the  management  that  rather  than  subject 
their  stock  to  the  prior  fixed  charges  of  such  collateral  trust 
notes,  the  stockholders  might  prefer  to  provide  the  means 


342  COKPOKATION   FINANCE 

of  purchase  by  an  increased  issue  of  stock,  the  preferred 
stock  of  the  Eubber  Goods  Manufacturing  Company  to  be 
acquired  by  an  issue  of  new  first  preferred  stock  of  the 
United  States  Company  in  amount  equal  to  that  of  the 
Manufacturing  Company,  and  with  dividends  limited  to  eight 
per  cent  annually." 

Even  where  bonds  can  safely  be  employed,  the  importance 
placed  upon  preserving  the  credit  of  the  purchasing  company 
influences  the  use  of  its  stock  to  acquire  other  stock.  The 
New  York,  New  Haven  &  Hartford,  for  example,  at  the  time 
of  its  acquisition  of  the  Boston  &  Maine,  could  undoubtedly 
have  purchased  this  stock  with  bonds.  The  Boston  &  Maine 
stockholders  had  been  in  receipt  of  a  seven  per  cent  dividend 
for  many  years,  and  had  no  reasonable  expectation  of  any 
higher  return.  It  is  not  to  be  doubted  that  they  would  have 
accepted  the  debenture  bonds  of  the  New  York,  New  Haven 
&  Hartford  secured  by  their  own  stock  quite  as  readily  as 
they  received  the  stock  of  the  purchasing  company.  By  ac- 
quiring the  Boston  &  Maine  stock  with  its  stock,  however,  the 
New  Haven  &  Hartford  maintained  its  credit  unimpaired. 
Any  mistake  in  its  calculations  as  to  the  increased  value  which 
association  with  the  Boston  &  Maine  would  confer  upon  that 
company's  stock,  would  not  damage  the  credit  of  the  purchas- 
ing company,  but  would  fall  upon  its  stockholders. 

From  the  standpoint  of  the  stockholder,  the  acceptance 
of  an  offer  for  his  stock  may  be  influenced  by  various  con- 
siderations. If  he  is  not  satisfied  with  the  prospects  of  his 
own  investment,  there  is  little  trouble  in  inducing  him  to 
accept  a  fair  offer.  For  example,  at  the  time  of  the  forma- 
tion of  the  United  States  Steel  Corporation,  the  Carnegie 
Steel  Company  threatened  with  its  competition  every  one 
of  the  large  industrials  whose  stockholders  were  asked  to 
exchange  their  holdings  for  United  States  Steel  stock.  The 
advantages  of  eliminating  this  competition,  and  of  being 
associated  in  the  same  company  with  the  strong  Carnegie 
Steel  Company,  were  sufficient  to  induce  a  practical  unani- 


CONSOLIDATION   OF   COKPORATIONS        343 

mous  acceptance  of  the  offer  of  the  United  States  Steel 
Corporation  to  the  stockholders  of  the  separate  companies. 

If,  however,  the  stockholder  is  receiving  good  dividends 
and  is  not  apprehensive  of  their  discontinuance,  strong  in- 
ducements are  usually  required  to  persuade  him  to  sell.  In- 
stances are  not  lacking  where  stockholders  have  given  up 
dividend  paying  stock  in  return  for  stock  which  paid  them 
nothing.  A  case  in  point  is  that  of  the  Atlantic  Transport 
Company,  whose  stockholders  went  into  the  International 
Mercantile  Marine  Company,  exchanging  their  stock,  on  which 
they  had  been  receiving  regular  dividends,  for  the  stock  of  a 
large  company  on  which  they  have  received  nothing.  With 
a  weak  company  or  a  new  company  offering  to  purchase,  and 
especially  when  a  corporation  is  organized  with  the  sole  pur- 
pose of  acquiring  the  stocks  of  other  companies,  unless  there 
are  strong  reasons  urging  consolidation,  and  unless  bonds  are 
not  available,  stock  will  not,  as  a  rule,  prove  attractive.  The 
stockholders  demand  either  collateral  trust  bonds  secured  by 
the  stock  purchased,  and  with  the  provision  in  the  indenture 
that  in  case  of  default  the  bonds  can  be  employed  to  purchase 
the  stock,  or  they  demand  cumulative  preferred  stock  bearing 
a  high  rate  of  dividend.  By  the  stockholders  of  the  strong 
companies  comprising  the  trusts,  a  bonus  of  common  stock  in 
addition  was  usually  exacted. 

As  a  compromise  between  the  stock  and  the  bond,  a 
company  purchasing  stock  may  employ  the  stock  trust  certifi- 
cate. In  1909,  for  example,  the  Minneapolis,  St.  Paul  & 
Sault  Ste.  Marie  Railroad  Company  acquired  most  of  the  pre- 
ferred stock  of  the  Wisconsin  Central  with  its  leased  line 
stock  certificates  secured  by  a  deposit  of  the  stock  purchased, 
on  which  four  per  cent  is  guaranteed  for  ninety-nine  years. 
These  stock  certificates  do  not  differ  essentially  from  a  collat- 
eral trust  bond.  In  case  of  default,  the  holders  of  the  certifi- 
cates receive  back  the  stock  from  the  trustee  and  can  sue  for 
unpaid  dividends.  The  obligation  of  the  certificate  is,  how- 
ever, a  contingent  obligation,  and  on  that  account  is  more 
acceptable  to  the  stockholders  of  the  purchasing  company. 


344  COKPOKATION   FINANCE 

No  matter  what  form  of  consideration  is  offered  for  the 
stock,  the  acceptance  of  the  offer  is  not  certain.  Some  stock- 
holders will  always  be  found  to  demand  cash  for  their 
holdings,  and  some  there  are  who  will  not  sell  at  any  price. 
This  situation  necessitates  the  usual  employment  of  the 
underwriting  syndicate  in  such  transactions,  which  guarantees 
the  provision  of  the  cash  required,  and,  in  some  cases, 
guarantees  the  delivery  of  the  amount  of  stock  necessary. 
The  oflBcial  circular  announcing  the  joint  offer  of  the  Great 
Northern  and  the  Northern  Pacific  to  purchase  the  stock  of 
the  Chicago,  Burlington  &  Quincy  stated  that  "The  pur- 
chasers will  pay  cash  instead  of  bonds  to  an  amount  not 
exceeding  in  the  aggregate  $50,000,000  to  those  shareholders 
who  shall  prefer  to  receive  payment  partly  in  cash ;  and  J.  P. 
Morgan  &  Company,  as  managers  of  a  syndicate,  have  under- 
taken to  provide  such  cash,  and  to  take  therefor  such  bonds 
at  par  and  accrued  interest.  You  are  accordingly  offered  the 
privilege  of  selling  your  stock  at  $200  per  share,  payable 
wholly  in  the  four  per  cents  described  above,  or  in  bonds  to 
the  amount  of  $160  and  cash  to  the  amount  of  $40." 

Another  precaution  usually  in  such  offers  is  to  make  the 
offer  contingent  upon  its  acceptance  by  a  certain  percentage 
of  the  stockholders  to  whom  it  is  made.  The  offer  just 
referred  to  was  for  not  less  than  two  thirds  of  the  stock  of 
the  Burlington.  When  the  syndicate  guarantees  the  delivery 
of  a  certain  amount  of  stock,  a  buying  campaign  is  usually 
the  preliminary  feature  of  the  transaction.  Preceding  the 
purchase  of  the  Burlington  stock,  and  also  preceding  the 
Rock  Island  consolidation,  the  stocks  of  these  companies 
showed  a  large  increase  in  value,  owing,  it  was  believed,  to 
the  operations  of  the  syndicates  interested  in  promoting  the 
consolidation.  The  purchasing  company  can,  of  course,  take 
no  official  part  in  this  buying  campaign,  however  essential 
though  it  may  be  to  the  execution  of  its  designs.  The  com- 
pany would  not  be  justified  in  using  its  funds  in  buying 
stock  for  which  it  might  have  no  use.  The  profits  of  syndi- 
cates under  these  circumstances,  although  severely  criticised. 


CONSOLIDATION   OF   CORPORATIONS        345 

have  been  defended  on  the  ground  that  in  no  other  way  could 
the  delivery  of  the  amount  of  stock  required  be  insured  than 
by  allowing  the  syndicate  to  make  what  profit  they  could  in 
purchasing  the  stock  below  the  figure  at  which,  as  they  are 
informed,  the  company  for  which  they  are  acting  is  prepared 
to  purchase  it. 


CHAPTER   XXIX 
THE  HOLDING  COMPANY  ' 

The  holding  company  is  a  corporation  organized  for  the 
purpose  of  acquiring  the  stocks  and  other  securities  of  other 
corporations.  These  securities  are  acquired  either  by  direct 
exchange  of  its  own  stocks  and  bonds,  or  by  their  sale  for  cash 
which  is  used  to  purchase  the  securities  desired.  The  owner- 
ship of  the  stocks  of  various  companies  gives  to  the  holding 
company  the  right  to  elect  their  boards  of  directors  and  to 
completely  dominate  their  policy,  thus  accomplishing  a  com- 
bination between  them  which  is  as  perfect  as  though  the  dif- 
ferent corporations  had  merged  their  existence  in  that  of 
the  company  which  has  acquired  a  controlling  interest  in 
their  stocks. 

Holding  companies  are  formed  both  for  legal  and  finan- 
cial reasons.  The  primary  purpose  of  forming  a  holding 
company  is  to  effect  a  combination  of  allied  enterprises  which 
cannot  be  accomplished  by  the  use  of  any  one  of  the  corpora- 
tions which  it  is  intended  to  include.  The  legalization  of 
consolidation  has,  in  most  states,  been  deferred  until  recent 
years.  If  corporations  are  organized  under  the  laws  of  dif- 
ferent states,  there  is  no  method  by  which  they  can  be 
directly  consolidated.  We  have  already  referred  to  the  for- 
mation of  the  trusts.  These  companies  have  been  generally 
organized  by  means  of  holding  companies  formed  under  the 
laws  of  the  State  of  New  Jersey.  The  conditions  out  of 
which  this  device  for  consolidating  competing  enterprises 
developed  will  show  in  detail  the  principal  legal  reason  for 
the  use  of  the  holding  company. 
346 


THE   HOLDING   COMPANY  347 

Many  attempts  had  been  made  before  1898  to  lessen  the 
recognized  evils  of  competition.  These  attempts  had  usually 
taken  the  form  of  pools,  many  of  which,  especially  in  the  iron 
and  steel  trades,  were  organized  during  the  last  industrial 
depression.  A  pool  is  a  voluntary  association  of  sellers  who 
place  the  marketing  of  their  product  under  some  central  con- 
trol or  general  restriction.  The  primary  object  of  such  agree- 
ments is  to  secure  profitable  prices,  either  directly  or  by  means 
of  payments  from  a  central  treasury,  to  the  members  of  the 
association.  The  methods  by  which  these  profitable  prices 
have  been  secured  are  in  general  as  follows:  (1)  The  output 
of  the  mills  included  in  the  association  is  restricted,  so  that 
prices  can  be  advanced  by  the  limitation  of  supply;  and  (2) 
the  buyer  is  held  to  the  regular  quotations,  and  is  unable, 
by  playing  off  one  competitor  against  another,  to  obtain 
special  concessions.  The  pool  may  go  further  than  the  regu- 
lation of  prices  and  output;  it  may  secure  favorable  terms 
on  material  purchased;  it  may  deal  as  an  association  with 
railroads  to  obtain  such  concessions  as  are  granted  to  large 
shippers,  and  it  may  assist  its  members  in  dealing  with  or- 
ganized labor.  As  a  general  proposition,  however,  the  pur- 
pose of  a  pool  is  to  regulate  production  and  control  prices, 
leaving  the  details  of  management  to  the  separate  companies. 

The  pool  is  usually  organized  with  a  central  governing 
or  advisory  body  which  conducts  all  routine  business,  and  re- 
ceives and  distributes  the  funds  of  the  organization.  A  mat- 
ter of  such  importance  as  a  change  in  prices  would  generally 
be  decided  at  a  meeting  of  all  the  members  of  the  association, 
or  by  some  executive  committee  composed  of  the  larger  manu- 
facturers. Within  these  lines,  the  pool  has  assumed  a  variety 
of  forms. 

The  Bessemer  Steel  Pool,  which  was  organized  in  1896, 
furnishes  an  illustration.  This  organization  included  the 
majority  of  the  producers  of  crude  steel  and  finished  material 
in  the  Central  West.  Every  mill  was  given  a  percentage 
allotment  which  it  was  allowed  to  sell — say,  500,000  tons,  or 
one  seventh  of  the  total  estimated  output  of  the  association. 


348  COKPOKATION   FINANCE 

At  the  end  of  each  month  the  shipments  from  all  the  mills 
were  reported  to  the  officers  of  the  pool.  If  any  mill  was 
found  to  have  exceeded  its  percentage  allotment,  it  was 
required  to  pay  into  the  pool  treasury  $2  per  ton  of  such 
excess,  while  an  equivalent  was  paid  out  of  the  treasury  to 
those  who  did  not  ship  their  allotment.  For  example,  if  the 
mill  which  was  allotted  500,000  tons  sold  700,000  tons,  while 
the  sales  of  another  mill  fell  200,000  tons  short  of  its  allot- 
ment, it  would  receive  out  of  the  pool  treasury  the  amount 
which  Mill  No.  1  would  pay  in— viz.,  $400,000.  The. ex- 
istence of  this  penalty  operated  to  prevent  price  cutting 
among  the  members  of  the  pool.  In  the  Wire  Nail  Asso- 
ciation, which  held  control  of  the  nail  market  during  1895 
and  1896,  the  central  office  fixed  prices  and  assigned  to  each 
producer  his  share  of  the  output,  which  it  was  believed  could 
be  marketed  at  the  price  agreed  upon.  It  often  happened 
in  the  management  of  a  pool  that  the  output  of  the  associa- 
tion would  be  produced  by  a  few  of  the  best-equipped  or 
best-situated  plants,  the  owners  of  the  idle  plants  being  paid 
a  certain  rental  to  keep  out  of  business. 

The  essential  weakness  of  this  form  of  organization  is  its 
inability  to  enforce  its  agreements.  The  necessity  of  volun- 
tary assent  on  the  part  of  every  member  of  the  association, 
the  liberty  of  each  to  withdraw  on  short  notice,  and  the  diffi- 
culty of  establishing  relations  of  mutual  confidence  among 
competitors,  all  unite  to  emphasize  this  defect.  The  mem- 
bers of  a  pool  have  long  since  formed  the  habit  of  closely 
scrutinizing  the  moves  of  those  in  the  same  business,  and 
even  a  small  misunderstanding  often  creates  a  feeling  of  mu- 
tual distrust  and  apprehension  which  work  the  destruction 
of  harmony  and  the  final  dissolution  of  the  organization. 

The  successful  management  of  a  pool  is  peculiarly  diffi- 
cult during  a  period  of  business  depression,  when  business 
at  remunerative  prices  is  hard  to  get.  Strong  producers  at 
such  a  time  are  suspected  of  attempts  to  obtain  more  than 
their  allotted  share  of  orders  by  methods  which  are  contrary 
to  the  spirit,  if  not  the  letter,  of  the  pool  agreement.     For 


THE   HOLDING   COMPANY  349 

example,  the  Bessemer  Steel  Pool,  above  referred  to,  origi- 
nally applied  only  to  the  tonnage  of  steel  billets,  ingots, 
bars,  or  slabs.  The  steel  which  was  rolled  into  merchantable 
shapes  did  not  count  in  the  allotment.  Some  of  the  large 
producers  took  advantage  of  this  fact  to  market  as  much  as 
possible  of  their  output  in  the  form  of  finished  material,  by 
this  method  of  indirection  far  exceeding  the  limits  of  their 
allotment,  and  they  could  not  be  penalized  for  so  doing. 
Such  offenses  against  the  pool  agreements  made  their  per- 
manent continuance  impossible. 

The  following  quotation  from  the  Iron  Age  of  December 
10,  1896,  shows  the  usual  fate  of  these  associations  and  the 
results  which  follow  their  dissolution :  "  The  Billet  Pool,  or 
Bessemer  Steel  Association  of  the  United  States  ...  is  now 
in  session.  .  .  .  The  meeting  promises  to  be  a  stormy  one, 
as  there  is  considerable  ill  feeling  against  certain  concerns 
who  are  charged  with  having  violated  the  pool  agreement. 
The  pool  was  practically  dissolved  as  soon  as  the  resignation 
of  the  Bellaire  Steel  Company  was  in  the  hands  of  the  sec- 
retary. There  has  been  an  open  market  on  Billets,  Sheet 
and  Tin-plate  Bars  since  Saturday  morning,  and  a  scramble 
for  business  on  the  part  of  some  mills.  Probably  25,000  tons 
of  Sheet  Bars  have  been  sold  this  week  at  very  low  prices, 
the  deliveries  running  up  to  the  close  of  1897.  There  have 
also  been  considerable  sales  of  Billets  and  Tin-plate  Bars  at 
low  prices." 

The  prices  which  follow  the  dissolution  of  a  pool,  when 
confidence  has  been  destroyed,  and  when  manufacturers  are 
making  concessions  to  secure  business,  are  often  even  lower 
than  the  low  prices  which  had  brought  the  producers  to- 
gether. Before  the  dissolution  of  a  rail  pool,  in  February, 
1897,  the  price  of  steel  rails  at  Chicago  was  $27.50  per  ton. 
Owing  to  the  dissatisfaction  of  the  Lackawanna  Iron  and 
Steel  Company  with  its  allotment  of  seventeen  per  cent  of  the 
total  output,  and  its  consequent  withdrawal  from  the  asso- 
ciation, and  owing  to  the  demand  of  the  Illinois  Steel  Com- 
pany for  all  territory  west  of  Pittsburg,  the  pool  was  dis- 


350  CORPOKATION   FINANCE 

rupted.  Steel  rails  were  immediately  offered  by  the  Car- 
negie Company  for  delivery  at  Chicago  at  $17  per  ton,  a 
reduction  of  $10.50  from  the  pool  price.  In  1895,  for  six 
months  before  the  organization  of  this  pool,  the  price  of 
rails  averaged  $21  per  ton.  After  the  dissolution  of  the  pool, 
the  price  did  not  again  reach  this  figure  until  January,  1899. 
The  breakdowns  of  pooling  agreements  in  the  steel  trade 
during  the  period  1892-98  occurred  with  such  periodical 
regularity  that  large  buyers  were  accustomed  to  wait  for 
the  dissolution  before  making  their  purchases.  After  the 
break  in  the  rail  pool  in  February,  1897,  the  Eastern  sales 
resulting  from  the  reduction  in  price  amounted  to  200,000 
tons.  The  Illinois  Steel  Company  in  the  West  booked  or- 
ders amounting  to  $5,000,000.  The  railroads  hastened  to 
load  up  the  rail  mills  with  large  orders,  often  for  delivery 
eighteen  months  in  the  future. 

Not  only  were  the  pool  agreements  unstable,  but  their 
regulation  of  prices  was  frequently  very  foolish.  The  de- 
termination of  the  policy  of  a  pool  is,  in  most  cases,  a  ques- 
tion of  majority  rule,  and  the  majority  of  producers  in  any 
trade  are  unlikely  to  be  possessed  of  a  broad  grasp  of  business 
situations,  or  to  be  able  to  see  further  than  the  immediate 
future.  When  they  found  themselves  in  control  of  the  sup- 
ply, the  various  associations  frequently  raised  prices  to  fig- 
ures which  seriously  interfered  with  demand  and  which  stim- 
ulated immediate  and  general  competition.  The  policy  of 
the  nail  pool  above  referred  to  offers  a  good  illustration  of 
this  tendency  to  extortion.  In  the  face  of  a  general  decline 
in  prices,  and  a  severe  depression  affecting  every  important 
industry,  the  price  of  a  keg  of  wire  nails  was  increased  from 
87  cents  to  $2.55,  a  rise  of  almost  200  per  cent,  and  this 
high  price  was  maintained  for  six  months. 

The  Iron  Age  characterized  this  policy  as  follows : 

"Looking  at  the  matter  even  from  the  manufacturer's 

standpoint,  it  would  seem  the  part  of  wisdom  to  have  put 

the  price  of  nails  at  a  reasonable  figure  rather  than  attempt 

to  maintain  a  price  which  in  the  very  nature  of  things  must 


THE   HOLDING   COMPANY  351 

be  temporary,  and  may,  perhaps,  end  in  disaster.  Only 
those  in  close  touch  with  the  trade  are  aware  of  the  influence 
which  the  policy  of  the  association  has  in  encouraging  the 
establishment  of  new  plants,  whose  competition  must  be 
troublesome,  while  at  the  same  time  it  invites  the  impor- 
tation of  foreign  nails.  .  .  .  The  trade  are  aware  that  the 
present  price  of  nails  is  abnormally  high  as  a  result  of  agree- 
ment between  the  manufacturers— so  high,  in  fact,  that  it  is 
constantly  under  suspicion.  The  trade  will  doubtless  con- 
tinue to  limit  their  purchases  to  their  imperative  require- 
ments so  long  as  nails  are  held  at  their  present  figures." 

Pooling  agreements  among  manufacturing  competitors 
are  inherently  defective.  They  have  no  firm  basis  in  mutual 
confidence.  They  usually  result  in  such  an  unreasonable  in- 
crease of  prices  as  to  check  consumption  and  stimulate  com- 
petition. In  few  cases  have  they  been  productive  of  more 
than  a  temporary  advantage  in  profits  to  their  members. 

The  "  Trust "  movement  of  the  eighties  promised  a  more 
satisfactory  restriction  of  competition.  In  this  form  of  or- 
ganization, agreement  among  manufacturers  as  to  prices  and 
output  was  secured  by  depositing  the  stocks  of  the  constitu- 
ent companies  with  trustees  in  exchange  for  trust  certificates. 
These  entitled  the  holders  to  such  dividends  as  might  be 
declared  on  the  stocks,  and  also  empowered  them  to  vote 
for  the  trustees  in  the  same  manner  as  the  stockholders  of 
a  corporation  elect  their  directors.  The  trust  certificates, 
moreover,  could  be  dealt  in  on  the  stock  •  exchanges  in  the 
same  way  as  the  certificates  issued  by  the  voting  trust  of  a 
corporation.  The  trustees,  being  in  control  of  the  stock  of 
the  several  corporations  included  in  the  trust,  directed  the 
management  of  these  companies,  and  secured  a  uniform  pol- 
icy upon  prices  and  output.  Permanence  of  control  was 
secured  by  making  the  transfer  of  stock  to  the  trustees, 
except  by  the  formal  dissolution  of  the  trust,  as  provided  for 
in  the  articles  of  association,  irrevocable. 

The  trust,  so  far  as  it  included  former  competitors,  fur- 
nished a  more  satisfactory  restriction  of  competition  than 


352  CORPOEATION  FINANCE 

the  pool.  It  was  open  to  fewer  objections;  its  organization 
was  permanent;  its  government  was  centralized,  responsible, 
and  representative.  The  control  of  the  constituent  corpora- 
tions by  the  central  organization — the  trustees — was  complete, 
for  the  trustees  elected  the  board  of  directors  of  each  of  the 
constituent  companies.  Because  it  was  permanent  and  cen- 
tralized, the  trust  pursued  a  more  enlightened  policy  as  to 
prices  than  the  pool.  The  Standard  Oil  Trust  made  a  con- 
siderable reduction  in  the  price  of  refined  petroleum,  and 
the  Sugar  Trust,  although  for  some  years  in  practical  con- 
trol of  the  market,  did  no  more  than  to  restore  prices  to  a 
living  basis.  The  Whisky  Trust  attempted  to  charge  exces- 
sive prices,  but  the  complete  failure  of  its  attempt,  owing 
to  the  growth  of  competition,  justified  the  wisdom  of  the 
more  conservatively  managed  organizations.  The  Cotton  Oil, 
Linseed  Oil,  and  Lead  Trust  showed  no  disposition  to  prac- 
tice extortion  upon  the  consumers  of  these  products.  The 
trust,  as  a  device  for  the  control  of  competition,  was  satis- 
factory. Its  legal  position,  however,  was  inherently  de- 
fective. 

Beginning  with  the  Granger  agitation  against  the  rail- 
roads in  1870,  there  had  grown  up  throughout  the  United 
States  a  pronounced  sentiment  against  monopoly,  under- 
standing by  monopoly  any  attempt  on  the  part  of  a  railroad 
or  manufacturing  corporation  to  increase  rates  or  prices  by 
reason  of  its  control  of  a  particular  market.  The  laws  of  most 
of  the  states  forbid  monopoly.  Many  state  constitutions  con- 
tain similar  provisions.  In  1890,  sixteen  states,  either  in 
their  constitutions  or  by  statute,  prohibited  any  combination 
in  restraint  of  trade;  and  the  common  law,  which  was  gen- 
erally applicable  throughout  the  states,  also  forbade  any  com- 
bination of  this  nature.  The  antitrust  law  of  Missouri,  for 
example,  prohibited  any  "  pool,  trust,  agreement,  combina- 
tion, confederation,  or  understanding  with  any  other  corpo- 
ration, partnership,  individual,  or  any  other  person  or  asso- 
ciation of  persons,  to  regulate  or  fix  the  price  of  any  article 
of  manufacture."     In  1890,  Congress  passed  the  Sherman 


THE   HOLDING   COMPANY  353 

Antitrust  Act,  which  declared  that  "every  contract,  combi- 
nation in  the  form  of  trust,  or  otherwise,  or  conspiracy  in 
restraint  of  trade  or  commerce  among  the  several  states 
or  with  foreign  nations,  is  hereby  declared  to  be  illegal." 
This  legislation  was  backed  up  by  a  vigilant  public  opinion 
rancorously  hostile  to  large  corporations.  It  was  not  to  be 
expected  that  the  trusts  would  long  survive  in  such  an  un- 
friendly atmosphere. 

The  pool  was  also  specifically  designated  by  most  of  these 
statutes  as  an  unlawful  combination,  but  the  pool  was  a  secret 
agreement  whose  details  were  not  a  matter  of  record  and 
against  which  it  was  difficult  to  secure  evidence.  The  Addy- 
stone  Pipe  and  Tube  Company  is  the  most  conspicuous  case 
of  the  dissolution  of  a  pool  by  legal  process,  and  here  the 
evidence  against  the  organization  was  only  secured  through 
information  given  by  a  disaffected  stenographer.  That  such 
pools  existed  was  common  knowledge,  but  to  obtain  conclu- 
sive evidence  was  difficult. 

The  trust,  however,  which  was  a  permanent  pool,  and 
which  was  expected  to  realize  the  benefits  of  the  pool  while 
avoiding  its  mistakes,  lay  open  to  attack.  The  trust  agree- 
ments were  matters  of  record.  Their  organizations  were 
made  under  the  usual  legal  forms,  and  the  details  of  these 
organizations  could  not  be  concealed.  The  trustees  could 
not  refuse  to  disclose  their  authority  for  issuing  the  trust 
certificates  which  were  dealt  in  on  the  exchanges.  Any 
stockholder  could  enforce  his  right  to  examine  the  consti- 
tution and  working  of  the  trust  which  held  his  property. 
Neither  could  the  fact  be  concealed  that  these  corporations, 
whose  identity  and  active  life  had  been  preserved,  were, 
under  the  trust  agreement,  no  longer  masters  of  their  own 
actions.  They  had  surrendered  their  delegated  powers  to 
the  trustees.  A  perfect  "  combination  in  restraint  of  trade  " 
had  been  effected,  and  in  view  of  the  manifold  statutes  pro- 
hibiting these  self-evident  combinations,  the  dissolution  of 
such  combinations  waited  only  for  an  attack  upon  their 
right  to  exist. 


354  COKPOEATION  FINANCE 

The  attack  came  in  1890,  when  the  Attorney-General  of 
New  York  brought  suit  against  the  North  River  Sugar  Re- 
fining Company  under  the  common  law.  The  case  was  de- 
cided against  the  company,  not  only  on  the  ground  as  stated 
in  the  opinion  of  the  Circuit  Court,  that  the  North  River 
Sugar  Refining  Company  was  a  combination  ..."  the  tend- 
ency of  which  is  to  prevent  competition  in  its  broad  and  gen- 
eral sense  and  to  control,  and  thus  at  will  enhance,  prices 
to  the  detriment  of  the  public,  .  .  .  but  because  the  corpora- 
tion, entering  the  trust,  had  exceeded  the  powers  of  its 
charter.  The  defendant  had  disabled  itself  from  exercising 
its  functions  and  employing  its  franchise  as  it  was  intended 
it  should  by  the  act  under  which  it  was  incorporated,  and 
had,  by  the  action  which  was  taken,  placed  itself  in  complete 
subordination  to  another  and  different  organization  to  be 
used  for  an  unlawful  purpose,  detrimental  and  injurious 
to  the  public.  This  was  a  subversion  of  the  object  for 
which  the  company  was  created,  and  it  authorized  the  Attor- 
ney-General to  maintain  and  prosecute  this  action  to  vacate 
and  annul  its  charter."  The  Standard  Oil  Trust  was  also 
declared  illegal  on  similar  grounds  by  the  Supreme  Court 
of  Ohio  in  1892. 

The  result  of  these  suits  showed  that  even  without  the 
new  menace  of  the  Federal  antitrust  law  the  legal  position 
of  the  trust  had  become  impossible.  The  states  had  pro- 
hibited all  combinations  in  restraint  of  trade.  The  corpo- 
riation  is  the  creation  of  the  state,  and  the  state  can  revoke 
the  powers  which  it  has  granted  when  these  powers  are  ex- 
ceeded or  unlawfully  exercised.  Certain  corporations  had 
combined  into  trusts  in  order  to  limit  competition — e.  g., 
to  restrain  trade.  These  corporations  had  exceeded  their 
powers,  they  had  violated  the  laws  of  the  states  which  had 
created  them,  and  their  charters  were  therefor  forfeited. 
Unless  some  new  device  could  be  discovered  by  which  the 
hardships  of  competition  could  be  alleviated,  the  pool  whose 
existence,  though  illegal,  could  be  partially  concealed,  and 
which  was  ordinarily  safe  from  legal  attack,  whenever  regu- 


THE   HOLDING   COMPANY  355 

lation  was  required,  must  still  be  employed-.  Its  defects  were 
generally  admitted,  and  it  often  aggravated  the  very  evils 
which  it  was  designed  to  cure;  but  if  the  trust  was  to  be 
forbidden,  the  pool  seemed  to  be  the  only  form  of  combina- 
tion possible. 

In  1892  the  Standard  Oil  Trust  solved  the  problem 
presented  by  the  illegality  of  the  trust  agreements  by  the 
application  of  the  principle  of  community  of  interest  to 
the  managment  of  its  various  constituent  companies.  This 
trust  was  dissolved,  and  the  stock  was  returned  to  the  hold- 
ers of  the  trust  certificates,  which  were  then  canceled. 
A  majority  of  the  stock  of  each  company,  however,  was  re- 
tained by  nine  men  who  had  been  prominent  in  the  affairs 
of  the  trust,  and  unanimity  of  action  was  in  this  way  se- 
cured. Such  an  arrangement  is  always  open  to  objection. 
It  depends  for  its  success  upon  the  maintenance  of  harmony 
among  the  members  of  a  group  of  individuals,  and  upon 
the  tensile  strength  of  the  ties  of  self-interest  supplemented 
by  the  bonds  of  friendly  association  and  personal  regard. 
The  control  of  the  various  Standard  Oil  companies  was  held 
by  the  members  of  a  single  family  and  their  close  personal 
associates.  These  men  had  long  been  identified  with  a  single 
interest,  and  the  feuds  of  the  competitive  struggle  had  not 
divided  them.  The  principle  of  community  of  interest  proved 
to  be,  in  this  case,  a  working  substitute  for  permanent  or- 
ganization. 

Generally  speaking,  however,  mutual  self-interest  backed 
by  the  friendship  of  members  of  a  group  of  business  men 
is  a  precarious  foundation  for  stability  of  prices  or  rates. 
Self-interest  may  lead  men  one  day  together  and  the  next 
day  it  may  lead  them  apart,  and  when  the  paths  of  self- 
interest  diverge,  friendship  is  usually  powerless  to  prevent 
a  break.  Community  of  interest,  as  applied  to  railroads  on 
May  9,  1901,  did  not  solve  the  difficulty.  Yet  the  threat- 
ened catastrophe  of  renewed  competition  among  the  members 
of  the  trust  must  be  prevented,  not  only  to  secure  the  ad- 
vance toward  stability  of  prices,  which  had  already  been 


356  CORPORATION  FINANCE 

made,  but  to  furnish  similar  solutions  for  other  vexing  prob- 
lems of  competition. 

Before  1889,  when  the  corporation  law  of  New  Jersey- 
was  revised,  the  laws  of  no  state  authorized  the  chartering 
of  a  corporation  for  the  general  purpose  of  owning  the  stocks 
or  property  of  other  corporations.  Consolidation  of  corpora- 
tions was  more  generally  permitted,  but  the  purchase  of  stocks 
of  other  corporations  by  a  holding  company  was  not  consid- 
ered to  fall  within  the  field  of  corporate  privilege.  There 
were  but  few  exceptions  to  the  general  rule  that  a  corporation 
should  be  organized  for  a  specific  purpose  or  for  closely 
allied  purposes.  Pennsylvania  had  gone  so  far  as  to  pro- 
hibit incorporation  for  more  than  one  purpose. 

Now  it  was  plain  that  the  trusts  could  be  preserved  if 
a  new  corporation  could  be  formed  which  was  empowered 
to  purchase,  either  for  cash  or  with  its  own  stock,  the 
stocks  of  the  several  companies  which  were  included  in  the 
trust,  and  which  it  was  desirable  to  keep  united  under  some 
form  of  permanent  control.  The  only  changes  which  would 
be  made  by  such  an  arrangement  in  the  organization  of  the 
combination  would  be  these:  (1)  To  substitute  for  the 
certificates  of  the  old  trust  the  shares  of  the  new  corpora- 
tion; (2)  to  change  the  relation  of  trustee  and  trust  into 
the  relation  of  owner  and  property;  and  (3)  to  substitute 
for  a  board  of  trustees  a  board  of  directors.  The  result 
would  be  a  single  corporation  whose  assets  were  the  secur- 
ities of  other  corporations,  each  one  in  the  full  possession 
of  its  corporate  faculties  and  exercising  all  of  its  lawful 
corporate  activities;  but  the  affairs  of  all  would  be  placed 
under  the  permanent  direction  of  the  company  owning  a 
controlling  interest  in  the  stock  of  each,  and  competition 
among  these  companies  would  thus  be  prevented.  The  hold- 
ing company,  if  this  course  seemed  preferable,  after  acquir- 
ing the  stocks  of  a  corporation,  could  dissolve  it,  remaining 
in  possession  of  the  property  which  the  canceled  stock  rep- 
resented, and  the  securities  holding  company  could  also  pur- 
chase the  property  of  partnerships  or  individuals  without  re- 


THE  HOLDING   COMPANY  357 

sort  to  the  expedient  of  organizing  them  into  corporations  in 
order  to  place  their  ownership  in  trust,  as '  was  formerly 
necessary. 

It  is  true  that  this  proposition  of  the  holding  company, 
first  broached  about  1890,  did  not  differ  in  principle  from 
the  illegal  trust  which  it  was  intended  to  supersede.  The 
same  combination  in  restraint  of  trade  existed  as  before.  If 
anything,  the  new  combination,  which  was  one  of  ownership 
and  not  of  trusteeship,  was  more  perfect  than  the  form  which 
had  just  been  declared  illegal.  The  suggested  plan  was  a 
violation  of  both  the  spirit  and  the  letter  of  the  antitrust 
laws  which  had  just  been  successfully  invoked  against  the 
Sugar  Trust.  A  company  whose  sole  reason  for  existence 
was  to  control  the  ownership  of  previously  competing  cor- 
porations had  manifestly  effected  a  combination  in  restraint 
of  trade.  All  this  was  admitted.  Moreover,  no  state  in 
which  the  sentiment  against  monopoly  was  strong  enough  to 
pass  and  to  enforce  the  antitrust  law  could  be  expected  so 
to  amend  the  statutes  of  incorporation  as  to  permit  the  or- 
ganization of  corporations  to  evade  that  law.  However  at- 
tractive the  proposition  might  be,  there  seemed  to  be  no  way 
to  bring  about  the  authorization  by  one  set  of  laws  of  a  kind 
of  corporation  whose  reason  for  existence  and  whose  purposes 
of  organization  the  laws  of  another  commonwealth  explic- 
itly forbade. 

The  difficulty  seemed  to  be  insurmountable.  For  the 
sake  of  profits  competition  must  be  restricted.  The  law 
said  that  its  restriction  was  illegal.  No  state  legislature  would 
have  run  the  risk  of  legalizing  the  formation  of  corporations 
to  perform  within  that  state  acts  which  would  have  necessi- 
tated the  repeal  of  an  antitrust  law  in  order  to  make  them 
lawful,  and  which  would  have  been  further  in  violation  of 
the  common  law.  But  in  these  three  italicized  words  lay  the 
salvation  of  the  trust.  Although  no  state  would  empower 
a  corporation  to  defeat  the  intention  of  its  own  statutes,  a 
state  was  found  to  pass  an  act  of  incorporation  which  ren- 
dered void  and  of  no  effect  the  antitrust  laws  of  every  state 
24 


358  COKPORATION   FINANCE 

attempting  by  statute  to  preserve  competition.  That  state 
was  New  Jersey. 

In  1889  the  Legislature  of  New  Jersey  amended  its  cor- 
poration laws  so  as  to  include  among  the  lawful  objects  of 
incorporation  the  right  to  purchase  the  stock  of  any  com- 
pany or  companies  owning  mining,  manufacturing,  or  pro- 
ducing materials,  or  other  property  necessary  for  their  busi- 
ness, and  to  issue  stock  in  payment  therefor. 

Under  the  provisions  of  this  act,  a  body  of  men  could 
form  a  corporation  under  the  laws  of  New  Jersey  which, 
among  other  manifold  privileges,  might  purchase  and  own  the 
stocks,  or  other  property  of  any  corporation  engaged  in  any 
kind  of  business  in  any  state,  providing  the  formation  of 
this  corporation  did  not  violate  any  law  of  New  Jersey,  on 
complying  with  the  following  easy  requirements:  (1)  To 
pay  a  small  fee  and  a  small  annual  tax;  (2)  to  maintain  a 
principal  office  in  the  State  of  New  Jersey  at  the  entrance  to 
which  the  name  of  their  company  is  conspicuously  displayed, 
and  where  a  legal  representative  of  the  company  can  be  found 
upon  whom  process  may  be  served;  (3)  to  keep  the  stock 
transfer  books  of  the  company  open  to  the  inspection  of  any 
stockholder  at  its  New  Jersey  office;  (4)  to  make  an  annual 
report  to  the  Secretary  of  State;  (5)  to  hold  their  annual 
stockholders'  meeting  at  the  New  Jersey  office  of  the  com- 
pany; and  (6)  to  have  as  one  of  their  directors  a  resident  of 
New  Jersey. 

For  momentous  consequences,  this  statute  of  New  Jersey 
is  hardly  to  be  equaled  in  the  annals  of  legislation.  Sixteen 
sovereign  states  had  passed  searching  and  stringent  laws  in 
prohibition  of  any  attempt  to  restrict  competition;  laws 
whose  detailed  minuteness  of  specification  could  hardly  be 
improved  upon;  which  had  been  proved  effective  against  the 
•  only  permanent  form  of  competition  regulation  yet  at- 
tempted, and  which  undoubtedly  represented  the  conviction 
of  a  majority  of  the  people  of  the  United  States — a  con- 
viction finding  more  general  and  authoritative  expression 
in  the   Sherman  Antitrust  Law,  and  strengthened  by  the 


THE   HOLDING   COMPANY  359 

antimonopoly  provisions  of  the  common  law;  a  well-nigh 
unanimous  sentiment  opposed  to  any  form  of  trust  or  pool; 
and  the  little  state  of  New  Jersey,  containing  two  per  cent 
of  the  population  and  one  and  three  tenths  of  the  wealth 
of  the  United  States,  by  the  simple  act  of  amending  its  cor- 
poration law,  nullified  the  antitrust  laws  of  every  state  which 
had  passed  them. 

A  trust  could  not  exist  in  New  York.  The  courts  of  New 
York  would  not  allow  the  creation  of  a  holding  company  to 
perpetuate  the  trust  under  another  and  slightly  different 
form.  Here  are,  say,  ten  corporations,  all  located  in  New 
York,  which  were  formerly  engaged  in  competition,  later 
organized  into  a  trust,  and  more  recently  dissolved  by  the 
New  York  courts.  The  owners  of  these  corporations,  having 
experienced  the  benefits  of  combination,  wish  to  continue 
their  organization  under  another  form.  They  apply  to  the 
New  York  Legislature  for  permission  to  charter  a  new  com- 
pany which  shall  purchase  all  their  stock,  and  whose  officers 
can  thus  control  their  united  policy.  The  Legislature  refuses 
the  application  on  the  ground  that  the  new  corporation 
would  be  the  old  trust  under  a  new  name,  and  would  there- 
fore be  existing  in  violation  of  the  same  law  which  had  been 
recently  employed  against  its  predecessor.  The  case  of  the 
stockholders  seems  hopeless.  They  are  citizens  of  New  York. 
Their  corporations  are  chartered  by  New  York.  New  York 
absolutely  forbids  them  to  combine  in  restraint  of  trade. 
What  are  they  to  do? 

In  despair  they  turn  their  eyes  southward.  There,  upon 
the  other  side  of  the  North  River  stands  the  State  of  New 
Jersey,  beckoning  them  with  welcoming  hands.  For  a 
franchise  bonus  or  fee.  New  Jersey  will  come  to  their  assist- 
ance. New  Jersey  will  authorize  them  to  form  a  corporation 
which  is  empowered  to  buy  the  stocks  of  their  ten  companies. 
New  Jersey  will  allow,  them,  as  a  New  Jersey  corporation, 
to  perfect  the  combination  in  New  York — for  operation  in 
New  York — ^which  the  laws  of  New  York  absolutely  forbid. 
New  Jersey  will  thus  deprive  the  State  of  New  York  of  the 


360  COKPORATION   FINANCE 

right  to  control,  in  the  interests  of  what  her  Legislature 
considers  to  be  public  policy,  the  corporations  which  New 
York  has  created  and  over  which  it  assumes  sovereign  power. 
New  Jersey  will  perform  a  similar  office  for  any  body  of 
individuals  who  may  wish  to  evade  the  antitrust  laws  of 
any  state  in  the  Union.  As  a  New  Jersey  corporation,  they 
may  combine  and  coalesce  for  the  operation  of  any  number 
of  competing  plants,  anywhere  in  the  United  States,  with 
none  to  molest  or  make  them  afraid. 

The  State  of  New  Jersey,  by  the  amendment  of  its 
corporation  laws  in  1890,  preserved  the  principle  of  combina- 
tion, and  made  the  modern  trust  possible.  It  is  true  that 
Delaware,  West  Virginia,  Maine,  and  New  York  have  fol- 
lowed the  example  of  New  Jersey.  From  present  appearances, 
moreover,  the  general  exodus  of  incorporators  to  those  states 
which  offer  them  the  largest  privileges,  and  charge  the  lowest 
incorporation  fees,  bids  fair  to  compel  most  of  the  other 
commonwealths  to  relax  their  restrictions.  New  Jersey, 
however,  was  the  first  state  to  liberalize  its  corporation  laws, 
and  to  New  Jersey  belongs  the  honor  of  first  discovering  that 
a  foreign  corporation  may  do  many  things  in  a  state  which 
a  domestic  corporation  is  by  the  laws  of  that  state  forbidden 
to  do. 

The  difference  between  the  old-time  trust  and  the  trust 
as  we  know  it  to-day,  and  the  nature  of  the  change  in 
combination-organization  which  has  taken  place,  may  be 
illustrated  by  the  table  on  page  361,  which  shows  the  meta- 
morphosis of  the  Sugar  Trust  in  1891. 

Industrially,  the  two  organizations  are  identical.  Their 
resources,  .their  equipment,  their  organization,  and  their 
market  are  the  same.  Legally,  however,  between  the  "  trust " 
and  the  "  industrial  combination  "  there  is  a  great  gulf  fixed. 
It  is  impossible  for  the  law  to  take  cognizance  of  the  fact 
that  the  American  Sugar  Refining  Company  is  the  old  Sugar 
Trust  under  another  form.  In  the  eyes  of  the  law,  the  Sugar 
Trust  died  when  the  shares  which  it  held  were  turned  back 
to  their  respective  owners.    The  law  is  in  no  way  concerned 


THE   HOLDING   COMPANY 


361 


THE  SUGAR  TRUST 

STOCK   OF    CONSTITUTENT    COMPANIES    IN    HANDS    OF 
TRUSTEES— TRUST  CERTIFICATES  OUTSTANDING 

THE  AMERICAN  SUGAR  REFINING  CO. 


Capital 
Stock 

Capital 

Assets 

Capital 
Stock 

1.  The   Havemeyer   &   Elder 

Sugar  Refining  Co 

2.  The  Dick  &  Meyer  Co 

3.  The   DeCastro   &    Donner 

Sugar  Refining  Co 

4.  The  Moller  &  Sierck  Co. .  .  . 

5.  The  Oxnard  Brothers  Co. .  . 

6.  The  F.  0.  Matthiessen  & 

Wirchers  Sugar  Refining 
Co 

$500,000 
200,000 

350,000 
210,000 
100,000 

400,000 
300,000 

1,000,000 
300,000 
650,000 

1,000,000 
225,000 
755,000 
450,000 
250,000 

$500,000 
200,000 

350,000 
210,000 
100,000 

400,000 
300,000 

1,000,000 
300,000 
650,000 

1,000,000 
225,000 
755,000 
450,000 
250,000 

7.  The   Brooklyn   Sugar   Re- 
fining Co 

8.  The  Havemeyer  Sugar  Re- 
fining Co. 

9.  The  Forest  City  Sugar  Re- 
fining  Co    

10.  The  Boston  Sugar  Refining 
Co .        

11.  The   Standard    Sugar   Re- 
fining Co 

• 

12.  The  Bay  State  Sugar  Re- 
fining Co 

13.  The  St.   Louis  Sugar  Re- 
fining Co 

14.  The  Louisiana  Sugar  Re- 
fining Co 

15.  The    Planters'    Sugar   Re- 
fining  Co. 

$6,690,000 
Valuation 

$6,690,000 
$50,000,000 

$50,000,000 

with  the  subsequent  sale  of  these  stocks  to  a  New  Jersey 
corporation. 

There  have  not  been  lacking  critics  to  scoff  at  the  change 
in  the  legal  form  of  the  trust  as  being  a  thing  of  little  conse- 
quence— a  mere  trick — a  subterfuge  to  evade  the  law.  A 
senator  not  many  years  since  aroused  much  ridicule  by 
stating  that  the  trust  no  longer  existed.     There  has  been. 


362  COKPOKATION   FINANCE 

however,  no  more  far-reaching  change  in  the  organization  of 
industry  than  that  which  converted  an  illegal  combination 
in  restraint  of  trade  into  a  corporation  organized  to  manu- 
facture and  sell  securities,  and  to  own  the  stocks  and 
properties  of  other  corporations  engaged  in  the  manufacture 
and  sale  of  commodities. 

By  reconstructing  the  "  trusts  "  to  conform  to  the  law, 
by  capitalizing  these  permanent  pools,  the  builders  of  the 
trusts  made  possible  a  widespread  reorganization  of  competi- 
tive industry  along  more  profitable  lines,  and  opened  the  way 
to  the  creation  of  the  huge  mass  of  industrial  securities 
which  represent  the  capitalization  of  manufacturing  industry 
in  the  United  St'ates,  from  participation  in  whose  profits 
the  public  has  before  been  excluded.  Without  this  device  of 
corporate  organization,  escape  from  competition  would  have 
been  impossible.  By  its  aid,  however,  the  profitable  regula- 
tion of  competition  was,  at  least  prospectively,  secured. 

The  legal  position  of  these  trusts  is,  however,  by  no  means 
certain.  The  permanent  success  of  Missouri  in  excluding 
from  its  boundaries  two  subsidiary  corporations  of  the  Stand- 
ard Oil  Company  on  the  ground  that,  by  allowing  their  stock 
to  pass  into  a  common  control,  they  had  incapacitated  them- 
selves from  obeying  the  antitrust  law  of  the  state,  shows  that 
if  the  state  authorities  care  to  exert  themselves  they  may  en- 
force their  anti-combination  laws  in  such  a  manner  as  to  de- 
prive the  holding  company  organized  under  the  laws  of  another 
state  which  of  course  they  have  no  power  to  reach,  of  control 
over  properties  which  come  under  their  own  jurisdiction. 
The  most  serious  danger  to  the  trust  lies  in  the  recent 
attempts  to  enforce  the  Sherman  Antitrust  Law.  This  law 
was  passed  in  1890.     Its  important  sections  are  as  follows: 

Section  1.  Every  contract,  combination  in  the  form 
of  trust  or  otherwise,  or  conspiracy,  in  restraint  of 
trade  or  commerce  among  the  several  states,  or  with 
foreign  nations,  is  hereby  declared  to  be  illegal. 

Every  person  who  shall  make  any  such  contract  or 
engage  in  any  such  combination  or  conspiracy,  shall 


THE   HOLDING   COMPANY  863 

be  deemed  guilty  of  a  misdemeanor,  and  on  convic- 
tion thereof,  shall  be  punished  by  fine  not  exceeding 
five  thousand  dollars,  or  by  imprisonment  not  exceed- 
ing one  year,  or  by  both  said  punishments,  in  the 
discretion  of  the  court. 

Section  2.  Every  person  who  shall  monopolize,  or 
attempt  to  monopolize  or  combine  or  conspire  with 
any  other  person  or  persons,  to  monopolize  any  part 
of  the  trade  or  commerce  among  the  several  states, 
or  with  foreign  nations,  shall  be  deemed  guilty  of  a 
misdemeanor,  and,  on  conviction  thereof,  shall  be  pun- 
ished by  fine  not  exceeding  five  thousand  dollars,  or 
by  imprisonment  not  exceeding  one  year,  or  by  both 
said  punishments,  in  the  discretion  of  the  court. 

The  first  suit  brought  under  the  Sherman  Antitrust  Law 
to  test  the  position  of  an  industrial  combination  was  in  1894 
in  the  case  of  the  United  States  vs.  E.  C.  Knight  Sugar 
Refining  Company.  That  company  had  just  purchased  four 
independent  refineries  in  Philadelphia,  and  action  was  brought 
to  enjoin  the  purchase  on  the  ground  that  a  combination  in 
violation  of  the  Sherman  law  had  been  formed.  The  Su- 
preme Court,  however,  to  which  the  case  was  carried  on 
appeal,  held  that  the  Sherman  Act  applied  only  to  combina- 
tions in  restraint  of  interstate  trade;  that  the  business  of 
the  American  Sugar  Eefining  Company  was  primarily 
manufacturing,  and  that  it  engaged  in  commerce  only  as  an 
incident  to  manufacture.  The  court,  therefore,  stated  that 
the  United  States  had  no  jurisdiction  over  the  combination 
since,  if  the  contrary  view  should  be  upheld,  the  effect  would 
be  to  give  the  Federal  government  control  of  all  enterprises 
whose  operations  cross  the  line  of  a  state,  and  this  unusual 
control,  which  would  reduce  the  power  of  an  individual  state  to 
a  nullity,  it  was  never  intended  that  Congress  should  possess. 

This  decision  was  rendered  in  1895.  Until  1902  it  was 
regarded  as  furnishing  complete  protection  to  the  industrial 
combinations.  In  1902,  however,  suit  was  brought  against 
the  Northern  Securities  Company,  a  New  Jersey  corporation 
organized  to  acquire  in  exchange  for  its  own  stock  the  stock 


364  COKPOKATION   FINANCE 

of  the  Northern  Pacific  and  Great  Northern  under  the 
Sherman  Antitrust  Law.  The  defense  was  that  the  North- 
ern Securities  Company  was  merely  an  investor,  and  that 
the  United  States  had  no  jurisdiction  over  the  lawful  invest- 
ments of  a  corporation  organized  under  the  laws  of  a  state. 
The  Supreme  Court,  by  a  bare  majority,  held  that  a  combi- 
nation in  restraint  of  trade  was  accomplished  by  the  joint 
ownership  of  the  stock  of  these  two  companies  by  the 
Northern  Securities  Company,  and  ordered  the  Northern 
Securities  Company  to  return  the  stock  to  their  original 
owners.  This  decision  struck  at  the  holding  company  prin- 
ciple. Its  application  to  railroads  was  not,  however,  regarded 
as  weakening  the  legal  position  of  manufacturing  combina- 
tions. The  recent  suits  against  the  Standard  Oil  Company, 
the  American  Tobacco  Company,  and  other  combinations,  how- 
ever, brought  under  the  Sherman  Act  by  the  Department  of 
Justice,  strike  directly  at  the  holding  company  in  the  field 
of  manufacturing  enterprise.  These  cases  are  still  before  the 
Supreme  Court,  which  has  shown  no  disposition  to  hurry  its 
decision. 

The  question  at  issue  turns  upon  the  definition  of  com- 
merce. If  the  decision  in  the  E.  C.  Knight  case  is  up- 
held, although  certain  trading  and  shipping  activities  of 
the  Standard  Oil  Company  and  the  American  Tobacco  Com- 
pany may  be  prohibited^  it  is  unlikely  that  these  holding 
companies  will  be  dissolved.  If,  however,  the  court  reverses 
its  opinion  expressed  in  the  E.  C.  Knight  case  and  inter- 
prets the  Sherman  Act  as  prohibiting  combinations  of 
manufacturing  concerns  which  ship  their  products  to  all 
parts  of  the  United  States,  then  the  legal  position  of  every 
one  of  the  combinations  is  unsound.  In  the  Tobacco  Trust 
case  in  the  Circuit  Court  of  the  Southern  District  of  New 
York,  Judge  Lacombe  said :  "  The  Sherman  Act  must  be 
construed  as  prohibiting  any  contract  or  combination  whose 
direct  effect  is  to  prevent  the  free  play  of  competition  and 
thus  tend  to  deprive  the  country  of  the  services  of  any 
number  of  independent  dealers,  however  small.    As  thus  con- 


THE   HOLDING   COMPANY  365 

strued  the  statute  is  revolutionary.  But  every  aggregation 
of  individuals  or  corporations  formerly  independent,  imme- 
diately upon  its  formation  terminates  an  existing  competition, 
whether  or  not  some  other  competition  may  subsequently 
arise.  The  act  as  above  construed  prohibits  every  contract 
or  combination  in  restraint  of  competition.  Size  is  not  made 
the  test.  Two  individuals  who  have  been  driving  rival 
express  wagons  between  villages  in  two  contiguous  states 
who  enter  into  a  combination  to  join  forces  and  operate  a 
single  line  restrain  an  existing  competition  and  it  would 
seem  to  make  little  difference  whether  they  make  such  com- 
bination more  effective  by  forming  a  partnership  or  not." 
The  amendment  of  the  law  is  apparently  impossible. 

Holding  companies  are  not  formed  solely  for  legal  reasons. 
Important  considerations  of  financial  expediency  favor  the 
use  of  this  device  when  it  is  desired  to  bring  under  single 
control  within  a  short  time  a  number  of  properties  in  the 
same  line  of  business.  When  it  is  desired  to  form  a  combi- 
nation, for  example,  of  a  number  of  steel  manufacturing 
concerns,  one  of  the  operating  companies  can  be  used  as  a 
holding  company,  or  a  new  company  can  be  formed.  Even 
if  no  legal  obstacles  intervened,  however,  the  holding  com- 
pany will  be  the  device  usually  selected. 

Mr.  Eobert  F.  Herrick,  in  a  paper  entitled  "  Holding 
Companies,"  originally  presented  before  the  Harvard  Gradu- 
ate School  of  Business  Administration,  has  summarized  the 
financial  reasons  for  employing  the  holding  company  in  such 
a  case  as  follows: 

"The  natural  purpose,  then,  of  a  holding  company  and 
the  one  for  which  it  is  used  is  the  combination  of  allied 
and  generally  though  not  necessarily  competing  enterprises. 
Theoretically,  such  a  combination  or  purchase  could  be 
effected  by  any  one  person  or  group  of  persons  with  sufficient 
capital.  Further,  it  could  be  effected  by  the  purchase  out- 
right, either  by  private  individuals  or  a  corporation,  of  the 
various  properties  or  business.    Practically,  however,  a  great 


366  COKPOKATION  FINANCE 

many  combinations  would  never  be  brought  about  except  for 
the  holding  company,  and  practically  all  of  the  great  recent 
consolidations,  such  as  the  United  States  Steel  Company, 
the  Amalgamated  Copper  Company,  and  others,  have  been 
holding  companies.  It  would  have  been  practically  impos- 
sible for  the  United  States  Steel  Corporation  to  have  been 
formed  in  any  other  way.  It  is  necessary  in  the  getting 
together  of  such  a  group  of  properties  to  act  quickly  and  at 
a  favorable  time.  It  is  necessary,  so  far  as  possible,  to  get 
along  without  new  cash.  The  amount  of  cash  necessary  to 
buy  the  properties  consolidated  into  the  United  States  Steel 
Corporation  would  have  been  impracticable  to  raise.  It  is 
necessary,  further,  as  much  as  possible  to  retain  the  interest 
of  a  large  number  of  stockholders  in  the  older  companies  in 
the  new  consolidated  company.  It  is  necessary  to  provide 
a  practical  working  method  of  bringing  them  all  together, 
and  particularly  necessary  to  provide  for  the  contingency 
that  it  may  be  impossible  or  impracticable  to  actually  sell 
the  property  of  one  of  these  corporations  to  the  consolidated 
company,  or  that  it  may  be  impossible  to  get  the  consent  of 
certain  of  those  interested  in  the  selling  company  to  the  con- 
solidation. 

"  The  stockholders  act  naturally  like  a  flock  of  sheep.  In 
the  main  they  follow  the  lead  of  the  directors,  and  if  the 
details  of  carrying  the  plan  through  are  so  arranged  that  the 
stock  in  the  new  company  has  an  apparent  money  value 
greater  than  the  stock  of  the  old  company  for  which  it  is 
offered,  the  exchange  once  started  takes  place  generally,  and 
when  a  majority  of  the  stock  in  the  companies  is  exchanged 
practically  the  consolidation  is  effected.  The  difficulty  in 
bringing  enterprises  together  in  any  other  way  can  be  realized 
when  you  appreciate  that  in  many  states  it  is  impossible  for 
a  corporation,  even  a  private  manufacturing  corporation,  to 
sell  out  its  entire  property,  including  franchises  and  good- 
will. It  has  been  held  in  some  jurisdictions  that  such  a 
sale  is  foreign  to  the  whole  purpose  for  which  the  corporation 
was  formed  and  that  when  the  time  for  such  a  sale  comes^ 


THE   HOLDING    COMPANY  367 

it  means  the  dissolution  of  the  corporation  and  a  final  dis- 
position of  its  assets  among  its  stockholders.  There  is  further 
in  certain  states  the  absolute  prohibition  for  a  corporation  of 
greater  than  a  limited  amount  of  capital  to  do.  business  in  the 
state.  This  alone  would  prevent  the  amalgamation  of  a  num- 
ber of  properties  into  one  great  corporation  directly  owning 
all  the  properties." 

Another  reason  for  choosing  the  holding  company  for  the 
consolidation  is  that  to  employ  an  operating  company  as  the 
purchaser  of  the  stocks  of  other  corporations,  would  require  a 
large  increase  in  the  stock  of  this  company,  and  this  increase 
might,  under  the  laws  of  the  state  or  the  charter  of  the  corpo- 
ration, require  the  consent  of  three  fourths  or  even  a  larger 
proportion  of  the  stock.  Stockholders  of  the  proposed  holding 
company  might  object  to  this  reorganization  of  the  capital 
account  for  a  purpose  of  which  they  might  not  approve,  and 
the  combination  might  be  halted  at  its  outset  by  embarrassing 
litigation  resulting  from  the  efforts  of  minority  stockholders 
to  protect  what  they  considered  to  be  their  rights  whatever 
the  motives  back  of  the  litigation. 

A  holding  company  has  various  other  uses  in  addition  to 
that  of  accomplishing  a  combination.  It  is  largely  employed 
as  a  finance  company.  One  of  the  best  illustrations  of  hold- 
ing companies  organized  for  this  purpose  is  furnished  by  the 
corporations  manufacturing  electrical  apparatus  and  appli- 
ances. The  products  of  the  General  Electric  Company,  for 
example,  are  purchased  by  corporations  engaged  in  the  opera- 
tion of  electric  railroads,  power  and  lighting  companies. 
When  these  companies  are  started,  their  promoters  usually 
welcome  assistance  in  providing  the  funds  for  construction. 
They  are  willing  not  merely  to  make  liberal  arrangements 
in  the  way  of  stock  bonuses,  but  also  to  give  to  the  con- 
struction companies  affiliated  with  the  banking  or  financial 
concerns  which  give  them  assistance  in  putting  through  their 
project,  exclusive  contracts,  not  merely  for  construction,  but 
also  for  all  materials  and  appliances  which  may  be  needed 


368  COKPOKATION   FUSTANCE 

for  a  long  time  to  come  in  the  maintenance  and  extension  of 
the  plant. 

The  companies  manufacturing  electrical  appliances  have, 
therefore,  placed  themselves  in  a  position  to  render  financial 
assistance  to  new  companies  in  order  to  secure  a  market  for 
their  machinery.  The  General  Electric  Company  owns  the 
entire  capital  stocks  of  the  Electric  Securities  Corporation 
and  the  Electric  Bond  &  Share  Company.  Both  of  these 
companies  are  finance  companies;  they  take  part  in  the 
underwriting  of  securities  of  electric  companies  of  various 
kinds,  and  also  purchase  the  bonds  of  such  companies,  some- 
times taking  with  the  bonds  a  bonus  of  stock.  They  obtain 
the  funds  for  these  purchases,  not  merely  because  of  the 
high  credit  which  the  backing  of  the  General  Electric  Com- 
pany gives  them,  but  also  by  selling  their  own  bonds  secured 
by  the  stocks  and  bonds  which  they  purchase.  The  Elec- 
trical Securities  Company,  for  example,  in  1904  offered  $500,- 
000  out  of  $1,000,000  collateral  trust  five  per  cent  bonds  se- 
cured by  $1,250,000  par  value  of  first  mortgage  bonds  of  nine 
electric  railway,  power  and  traction  companies  located  in  dif- 
ferent parts  of  the  United  States.  These  companies  earned 
a  surplus  over  fixed  charges,  and  the  Electrical  Securities 
Corporation  was  required  to  keep  the  principal  acquired  out 
of  its  interest-paying  bonds  under  pledge  equal  at  all  times 
to  at  least  125  per  cent  of  the  principal  of  the  collateral  trust 
bonds  outstanding.  When  a  favorable  opportunity  occurs, 
bonds  may  be  withdrawn  and  sold,  a  corresponding  amount 
of  the  collateral  trust  bonds  being  paid  off.  In  other  cases, 
the  substitution  of  collateral,  according  to  the  method  already 
explained  in  the  discussion  of  the  collateral  trust  bonds,  is 
permitted. 

By  pledging  the  bonds  which  it  purchases  as  collateral 
for  loans,  a  corporation  of  this  character  is  able  to  free  its 
capital  for  new  employment  without  selling  unseasoned  bonds 
at  the  low  prices  which  such  securities  bring.  The  bonds  can 
be  put  away  under  the  collateral  trust  mortgage  until  the  com- 
panies issuing  them  have  reached  an  assured  position,  when 


THE  HOLDING   COMPANY  369 

they  can  be  sold  at  a  substantial  advance  over  the  price  paid. 
Bonds  purchased  by  such  corporations,  moreover,  often  carry 
a  bonus  of  stock,  and  the  stock  can  either  be  held  for  dividends 
or  sold  as  soon  as  it  reaches  a  proper  figure. 

A  limit  is  usually  placed  upon  the  amount  of  collateral 
trust  bonds  which  such  a  corporation  can  issue.  In  the  case 
of  the  Electrical  Securities  Company,  for  example,  the  "  total 
indebtedness  of  the  corporation,  secured  and  unsecured, 
direct  and  contingent,  shall  never  in  the  aggregate  exceed 
four  times  the  amount  of  its  paid-up  and  unimpaired  out- 
standing capital  stock  and  surplus."  Bonds  of  such  a 
corporation,  issued  under  these  restrictions,  furnish  very 
good  security.  The  fact  that  the  collateral  pledged  represents 
the  bonds  of  a  number  of  different  enterprises  adds  to  the 
safety  of  these  obligations. 

The  object  of  the  Electrical  Securities  Corporation  and 
the  Bond  and  Share  Company  is  to  assist  the  owner  of  their 
stock,  the  General  Electric  Company,  in  pushing  its  business. 
It  is  not  their  object  to  retain  permanently  the  bonds  which 
they  purchase.  As  fast  as  these  show  a  substantial  profit, 
they  are  sold  and  the  proceeds  reinvested  in  other  securities. 
Other  companies  have  been  organized  on  this  model  for  the 
purpose  of  permanent  income  to  be  derived  from  the 
securities  yielding  the  high  rate  of  return  purchased  with 
their  own  bonds  at  a  lower  rate.  The  Mortgage  Bond  Com- 
pany of  New  York,  for  example,  owns  first  mortgages  in  a 
large  number  of  cities,  and  from  time  to  time  issues  bonds 
secured  by  these  mortgages  with  the  proceeds  of  which 
other  mortgages  are  purchased.  The  bonds  of  this  company 
must  at  all  times  be  secured  by  deposit  with  the  trustee  of 
first  mortgages  equal  in  face  value  to  the  value  of  the  bonds 
outstanding  on  improved  real  estate  in  cities  having  a  popu- 
lation not  less  than  40,000,  subject  to  the  right  of  the  com- 
pany temporarily  to  deposit  cash.  Government  bonds,  or  New 
York  City  bonds  at  a  valuation  of  five  per  cent  below  the  mar- 
ket value  thereof.  All  the  mortgages  used  as  collateral  are 
limited  to  one  half  of  the  value  of  the  mortgaged  property  as 


370  CORPORATION   FINANCE 

appraised  for  the  company.  With  cities  having  a  population 
of  300,000  or  over,  such  mortgages  may  equal  three  fifths  of 
the  value  of  the  property,  and  in  New  York  City,  two  thirds 
of  the  value.  These  bonds  are  issued  at  low  rates  of  interest, 
and  their  proceeds  can  be  loaned  at  rates  which  show  a  sub- 
stantial margin  of  profit  for  the  stock.  The  mortgage  bond 
indebtedness  of  the  company  is  limited  to  fifteen  times  the 
capital  stock  outstanding  at  the  time  of  issue.  Other  illustra- 
tions of  holding  companies  organized  for  permanent  control 
of  properties  are  the  American  Water  Works  Company,  the 
American  Pipe  Manufacturing  Company,  the  American  Gas 
Company,  the  American  Light  &  Traction  Company,  and  the 
United  Gas  Improvement  Company. 

The  finance  holding  companies  which  have  been  described 
are  similar  to  the  organization  of  the  investment  trusts  which 
are  numerous  in  Great  Britain.  These  corporations  are  or- 
ganized to  make  available  to  the  general  investor  the  stocks 
and  bonds  of  other  companies,  thereby  relieving  him  of  the 
task  of  finding  safe  investments  for  his  money.  Invest- 
ment Trusts  issue  shares  or  debentures  bonds  to  the  investor, 
and  with  the  funds  obtained,  they  purchase  large  blocks  of 
securities  in  various  companies,  many  of  them  located  outside 
of  England.  It  is  not  regarded  essential  that  these  interests 
should  be  controlling  interests.  In  some  cases,  new  flotations 
can  get  their  capital  from  such  investment  trusts.  The  pur- 
pose of  these  investment  holding  companies  is  indicated  in 
the  prospectus  of  the  General  Investors  &  Trustees,  Limited, 
which  says: 

This  company  has  been  formed  to  conduct  the 
business  of  a  trust  and  investment  company.  .  .  .  The 
directors  believe  that  the  present  is  a  favorable  time 
for  engaging  in  such  an  enterprise,  securities  being 
generally  free  from  inflation,  and  the  conditions  of 
trade  throughout  the  world  being  of  a  satisfactory 
character.  It  has  been  shown  by  experience  that  a 
well-managed  investment  company  enjoys  many  ad- 
vantages which  are  not  usually  within  the  reach  of  a 
private  individual,  who  cannot  generally  exercise  that 


THE   HOLDING   COMPANY  371 

vigilance  essential  to  successful  results.  The  former 
is  in  a  position,  while  as  a  rule  a  private  investor  is 
not,  to  make  the  investigations  necessary  to  ascertain 
the  real  position  and  intrinsic  value  and  prospects  of 
the  undertakings  in  which  it  contemplates  investing 
its  capital.  The  information  now  required  to  be  given 
by  companies  under  recent  legislation  in  conjunction 
with  their  annual  reports  and  accounts,  provides  a 
useful  index  to  their  merit,  and  furnishes  an  invalu- 
able aid  to  the  operations  of  a  trust  and  investment 
company.  The  business  of  participating  in  the  un- 
derwriting of  new  issues  of  Home,  Foreign,  and 
Colonial  Loans,  and  of  bonds,  debentures  and  deben- 
ture stocks,  and  shares  and  stocks  of  approved  com- 
panies, will  form  a  prominent  feature  of  the  com- 
pany's operations. 

The  advantages  of  such  a  company  are  many.  In  the 
first  place,  it  can  act  as  an  underwriter  in  taking  over  the 
stocks  and  bonds  of  new  corporations  in  which  it  has  confi- 
dence at  very  low  prices,  receiving  occasional  bonuses  of 
stock,  and  selling  its  own  shares  or  debenture  bonds  on  an 
investment  basis.  This  is  essentially  the  same  plan  as  that 
followed  by  railroad  companies  which  build  branch  lines 
through  subsidiary  companies,  and  then  sell  securities  of 
these  companies  in  the  form  of  their  own  collateral  trust 
bonds  to  the  public.  The  Investment  Trust  Company  has 
also  this  advantage  over  the  investment  banker  because  the 
latter  is  compelled  to  turn  over  its  capital  quickly,  and  is 
forced,  in  order  to  market  securities  purchased,  to  give  the 
purchaser  lower  prices  than  those  which  could  be  obtained 
for  these  securities  if  they  were  held  until  the  company  had 
fully  demonstrated  its  earning  power.  The  English  invest- 
ment trust,  moreover,  may  retain  its  purchases,  or  may  sell 
these  securities  when  they  appreciate  in  value  as  result  of  in- 
creased earnings.  In  either  case,  its  shareholders  obtain  the 
full  benefit  of  appreciating  value  which  the  American  banker 
is  forced  to  divide  with  his  customers.  The  second  point  in 
favor  of  the  investment  holding  company  is  that  it  spreads  its 


372  CORPORATION  PINANCE 

investments  over  a  wide  field,  by  which  it  can,  in  the  same 
manner  as  life  insurance  companies,  reduce  the  risk  of  loss  to 
a  minimum.  The  investor  in  its  debentures  or  shares  can  also 
be  safeguarded  by  reserve  funds  built  up  out  of  the  dividends 
and  interest  which  it  receives. 


CHAPTER   XXX 
THE   LEASE 

The  lease  has  already  been  defined  as  a  contract  by  which 
possession  of  certain  property  is  transferred  from  the  owner 
known  as  the  lessor  to  some  other  person  or  corporation 
known  as  the  lessee.  Corporate  leases  contain  the  following 
provisions : 

First,  a  description  of  the  property,  usually  in  the  form 
of  a  complete  inventory,  which  must  be  kept  up  to  date,  since 
the  nature  of  corporate  property  is  likely  to  be  constantly 
changing.  For  example,  the  property  of  a  street  railway 
company,  where  the  motive  power  is  in  turn  changed  from 
horse  power  to  cable,  then  to  the  overhead  trolley,  and  finally 
to  the  underground  trolley,  may  be  entirely  different  at  the 
end  of  a  ten-year  period  from  what  it  was  at  the  beginning. 
If  this  property  is  to  be  leased  to  another  company,  it  is  im- 
portant that  the  inventory  be  revised  at  regular  intervals. 

Second,  the  length  of  the  lease.  It  is  usual  to  make 
corporate  leases  for  long  terms,  ninety-nine  years  being 
common,  and  999  years  not  unusual.  When  leases  are  made 
for  shorter  periods,  options  of  renewal  on  certain  terms  are 
usually  inserted. 

Third,  payments  under  the  lease.  With  hardly  an  excep- 
tion, corporate  leases  provide  that  taxes,  insurance,  interest, 
and  expenses  of  maintaining  the  organization  of  the  lessor 
shall  be  paid  by  the  lessee.  In  addition,  the  payment  for 
the  lease  to  the  lessor  is  usually  made  in  the  form  of  a  divi- 
dend upon  the  capital  stock  of  the  lessor  as  then  outstanding. 
It  may  also  be  provided  that  the  lessee  shall  pay  as  rental 
25  373 


374  COKPOKATION   FINANCE 

for  the  property  a  certain  proportionate  part  of  the  gross 
earnings  or  of  the  net  earnings.  This  method  places  no 
limit  to  the  participation  of  the  owner  in  the  profits  of  the 
property.  These  payments  are  frequently  made  on  a  sliding 
scale  so  as  to  permit  the  stockholders  to  share  in  the  expected 
increase  in  profits. 

Corporate  leases  provide,  in  even  greater  detail  than 
private  leases,  for  the  maintenance  of  the  property.  This 
point  needs  to  be  far  more  carefully  guarded  in  short  term 
leases  than  when,  for  example,  ninety-nine  year  leases  are 
made.  If  the  maintenance  of  leased  property  is  not  care- 
fully looked  after,  as  the  date  when  the  lease  expires  ap- 
proaches, the  lessee,  unless  he  expects  to  renew  the  lease,  will 
allow  the  condition  of  the  property  to  deteriorate,  making  as 
much  money  as  possible  during  the  last  year  or  two  of  his 
occupancy.  In  order  to  protect  the  lessor  against  such  an 
abuse  of  his  rights  by  the  lessee,  there  may  be  reserved  to 
the  lessor  the  privilege  of  examining  its  physical  condition. 
A  typical  provision  for  maintenance  is  the  following,  taken 
from  the  lease  of  the  property  of  the  Manhattan  Railway 
Company  to  the  Interborough  Rapid  Transit  Company: 

The  lessee  covenants  and  agrees,  at  its  own  proper 
cost  and  expense,  to  maintain,  operate  and  run  the 
demised  railroads  and  property  during  the  said  term 
in  the  same  manner  as  the  lessor  is  now  or  shall  at 
^any  time  hereafter  be  required  or  authorized  by  law 
to  do;  and  shall  and  will  keep  all  insurable  property 
insured  in  reasonable  amounts  and  rebuild  all  build- 
ings and  replace  all  property  destroyed  or  deterio- 
rated by  fire  or  otherwise,  to  such  an  extent  as  to  be 
unfit  for  use;  and  shall  and  will  maintain,  preserve 
and  keep  the  railways  and  property  hereby  demised, 
including  all  property  hereafter  acquired,  and  every 
part  thereof,  in  thorough  repair,  working  order  and  safe 
and  efiicient  condition,  and  supplied  with  rolling  stock 
and  equipment,  so  that  the  business  of  the  said  de- 
mised railways  shall  be  preserved,  encouraged  and  de- 
veloped, the  business  thereof  be  done  with  safety  and 
expedition,   the  public   be   accommodated   in   respect 


THE  LEASE  375 

thereto,  with  all  practicable  convenience  and  facilities, 
and  the  future  growth  of  such  business  as  the  same 
may  arise  or  be  reasonably  anticipated  be  fully  pro- 
vided for  and  secured. 

The  lessee  further  covenants  and  agrees,  at  the  ex- 
piration or  termination  of  this  lease  for  any  cause, 
to  return  and  deliver  the  said  railroad  and  railroads, 
real  estate,  and  properties  by  this  lease  demised,  in- 
cluding, among  other  things,  all  property,  additions, 
improvements  and  equipments  which  shall  be  fur- 
nished, constructed  or  completed  out  of  the  proceeds 
of  sale  of  the  stock,  bonds  or  property  of  the  lessor,  to 
the  lessor  in  as  good  order,  condition  and  repair  as 
they  were  at  the  date  this  lease  takes  effect,  or  at  the 
date  when  the  same  came  into  the  possession  of  the 
lessee,  and  to  surrender  said  franchises,  rights  and 
privileges,  easements  and  properties  unimpaired  by 
any  act  of  the  lessee;  excepting,  however,  all  property 
of  the  lessor  sold  pursuant  to  the  terms  hereof,  the 
proceeds  of  which  shall  have  been  applied  as  herein 
provided. 

The  lessee  further  covenants  and  agrees  that  it  will, 
at  all  times  during  the  continuance  of  this  lease, 
at  its  own  expense,  keep  the  said  rolling  stock,  and 
tools,  equipment,  machinery  and  implements  necessary 
for  the  operation  of  the  road,  in  good  order,  condition 
and  repair,  and  will,  as  the  same  shall  be  worn  out 
and  rendered  unserviceable,  replace  the  same  at  its 
own  expense,  so  that  the  said  railroad  and  railroads 
shall  always  be  kept,  maintained  and  equipped  in  good 
and  safe  condition  and  effective  working  order. 

The  lessee  further  covenants  and  agrees  that  it  will 
at  all  times  during  the  continuance  of  this  lease,  at 
its  own  expense,  comply  with  all  lawful  requirements 
with  respect  to  the  construction,  maintenance  and 
operation  of  said  railroads,  extensions  or  branches 
thereof. 

In  corporate  leases,  when  the  instrument  covers,  for 
example,  a  large  and  complex  street  railway  system,  it  fre- 
quently happens  that  some  portion  of  the  property  of  the 
lessor  is  no  longer  of  use  to  the  lessee.    It  is  for  the  interest 


376  COEPORATION  PINANCE 

of  both  parties  that  this  property  should  be  sold.  Provision 
is  usually  made,  therefore,  for  the  sale  of  such  property,  with 
or  without  the  consent  of  the  lessor,  but  invariably  with  the 
stipulation  that  the  proceeds  of  the  sale  are  to  be  invested  in 
improvements  upon  the  lessor's  property.  In  other  respects 
the  language  and  form  of  a  corporate  lease  closely  follows 
the  corporate  mortgage,  the  main  objects  being  to  preserve 
the  physical  condition  of  the  property  and  to  protect  the 
lessor  against  any  claims  or  charges  arising  from  the  non- 
fulfillment of  any  obligation  connected  with  the  property 
released.  If  the  property  is  mortgaged,  such  a  stipulation  is, 
of  course,  necessary,  and  the  consent  of  the  trustee  of  the 
mortgage  must  be  obtained. 

A  proposition  made  by  a  strong  company  to  stockholders 
of  another  corporation  to  lease  their  property  at  a  rental 
corresponding  to  the  dividends  which  they  are  then  receiving 
or  of  which  there  is  an  immediate  prospect,  is  very  attrac- 
tive, and  it  is  not  so  essential  to  make  sure  of  their  acceptance 
by  purchasing  enough  stock  to  control  the  board  of  directors 
of  the  lessor  company,  as  when  a  proposition  is  made  to  pur- 
chase tlie  stock.  A  typical  proposition  of  this  character  is 
indicated  in  the  following  offer: 

The  Indianapolis  Terminal  and  Traction  Company 
offers  to  lease  the  property  of  the  Indianapolis  Street 
Railway  Company,  guaranteeing  the  payment  of  inter- 
est, taxes,  etc.,  and  also  dividends  on  the  street  railway 
stock  of  one  per  cent  on  January  1 ;  next,  and  there- 
after semiannually  3  per  cent  for  the  first  year,  4  per 
cent  for  the  second  year,  5  per  cent  for  the  third  year, 
and  from  July,  1908,  6  per  cent.  The  term  of  the  lease 
is  for  thirty  years,  which  is  the  unexpired  life  of  the 
Indianapolis  Company's  franchise  from  the  city. 

The  advantages  of  the  lease,  from  the  standpoint  of  the 
lessee,  are  equally  evident.  The  lessee  company  obtains  the 
control  of  property  without  the  outlay  of  any  money,  and 
usually  on  terms  which  leave  them  a  margin  of  profit  after 
making  the  payments  required  by  the  lease.     If  property  is 


THE   LEASE  377 

to  be  built  a  large  amount  of  financing  is  necessary.  Bonds 
or  stock  must  be  sold,  and  extensive  construction  operations 
entered  into.  If,  however,  the  property  desired  can  be  rented 
from  its  owners,  the  lessee  company  comes  immediately  into 
the  possession  of  a  fully  completed  property,  manned  by  an 
operating  organization  and  on  a  profitable  basis.  The  same 
result,  from  the  standpoint  of  control,  may  be  reached  by 
purchases  of  the  stock  of  the  company  owning  the  desired 
property,  which  can  be  pledged  under  an  issue  of  collateral 
trust  bonds.  This  method  has  already  been  explained.  Here, 
however,  the  question  of  financing  arises,  the  bonds  must  be 
sold,  or  a  sufficient  sale  must  be  insured  by  a  syndicate  to 
purchase  the  amount  of  stock  desired.  The  question  of  stock, 
moreover,  as  we  have  seen,  usually  involves  the  entire  issue 
of  the  company  which  owns  the  desired  property,  and  the 
financing  may  be  extensive.  To  acquire  control  by  the 
method  of  lease,  however,  involves  only  dealing  with  the 
board  of  directors,  and  the  submission  by  them  of  a  proposi- 
tion to  the  stockholders.  If  the  offer  is  advantageous,  and 
with  the  prestige  of  the  directors  behind  it,  it  is  likely  to  be 
unanimously  accepted. 

Leased  property  has  objections  from  the  point  of  view 
of  the  lessor.  It  is  not  available  as  security  for  loans  to  pay 
for  improvements  which  may  increase  its  value.  While  the 
property  of  a  street  railway  system  is  in  the  possession  of 
the  lessee  company,  and  while  its  operation  is  entirely  con- 
trolled by  the  lessee,  title  to  the  property  remains  in  the 
lessor.  In  the  natural  course  of  improvement,  with  a  steady 
growth  of  population,  large  extensions  and  additions,  and  a 
considerable  amount  of  reconstruction  of  the  property,  are 
reasonably  certain.  The  progress  of  invention  has  completely 
revolutionized  the  methods  and  mechanism  of  street  railway 
corporations.  The  motive  power,  types  of  cars,  the  methods 
of  generating  power  and  the  types  of  track,  have  been  greatly 
improved.  The  cost  of  all  these  improvements  and  exten- 
sions which  are  made  upon  the  property  of  the  lessor,  in  the 
absence  of  special  provisions  in  the  lease,  must  be  borne  by 


378  COKPORATION  FINANCE 

the  lessee  company.  With  a  short  term  lease,  the  improve- 
ment of  the  lessor's  property  may  be  the  ground  for  a 
successful  demand  for  higher  rental  from  the  lessee,  and 
improvements  are  likely  to  be  deferred  or  abandoned  on  this 
account.  With  a  long  term  lease,  the  only  objection  to  im- 
proving the  lessor's  property  is  the  difficulty  of  financing 
the  cost  of  these  improvements.  In  such  cases,  the  only 
property  right  held  by  the  lessee  is  the  lessor's  interest 
obtained  by  capitalizing  the  profits  of  the  lease.  This  right 
may  in  some  cases  be  very  valuable.  We  have  already  seen 
that  it  was  one  of  the  assets  pledged  by  the  Interurban  Eapid 
Transit  Company  as  security  for  a  recent  issue  of  bonds.  In 
few  cases,  however,  are  the  profits  so  large  as  to  make  the 
lessor's  interest  of  great  value,  and  great  difficulty  may  be 
experienced  in  financing  improvements  which  are  absolutely 
essential  to  the  development  of  the  system,  and  which  may, 
in  fact,  be  demanded  by  the  public  authorities. 

A  recent  illustration  of  the  difficulty  experienced  by  the 
lessee  company  under  these  circumstances  is  furnished  by 
the  Philadelphia  Rapid  Transit  Company  which  holds  under 
lease  the  street  railway  property  of  the  Union  Traction  Com- 
pany which  preceded  it  in  control  of  the  street  railway 
system  of  Philadelphia.  In  September,  1908,  the  Rapid 
Transit  Company  sent  a  letter  to  the  shareholders  of  the 
Union  Traction  Company  which  is  as  follows: 

'^  On  July  1,  1902,  you  turned  over  to  this  company 
your  property  on  a  rental  basis.  You  had  acquired  this 
property  seven  years  before,  had  expended  jour  money  in 
the  development  of  it,  and  while  in  later  years  you  had 
shown  a  surplus  from  operation,  that  surplus* had  not,  up 
to  that  time,  been  sufficient  to  justify  the  payment  of  a 
dividend. 

"This  company,  by  the  terms  of  the  lease,  undertook. to 
pay  you  a  dividend  from  the  start,  equal  to  the  largest 
earnings  which  you  had  shown  up  to  that  time,  and  in- 
creasing until  they  should  reach,  as  they  now  have,  double 


THE   LEASE  379 

that  amount.  In  the  past  six  years  we  have  spent  approxi- 
mately $20,000,000  in  building  the  new  elevated  and  subway 
railway  and  $20,000,000  upon  improvements,  and  extensions 
of  the  system  which  you  turned  over  to  us.  This  company 
has  been  subject  to  severe  criticism  for  having  assumed  to 
pay  a  dividend  upon  the  par  value  of  your  stock,  only  thirty- 
five  per  cent  of  which  has  been  paid  in,  but  the  answer  is 
that  we  have  (in  effect)  spent  upon  this  system  not  only  the 
19^  millions  remaining  unpaid  upon  your  capital  stock  but 
10^  millions  additional,  with  respect  to  which  $30,000,000  no 
fixed  charge  has  been  assumed  and  no  return  has  been  paid. 

"  The  increased  cost  of  operation,  the  recent  depression  in 
business  and  unavoidable  delays  in  the  completion  of  the 
subway  have  necessarily  upset,  to  a  certain  extent,  the  cal- 
culations upon  which  the  rental  obligations  were  based. 
These  conditions,  however,  have  merely  postponed  the  fulfill- 
ment of  our  expectations,  and  the  management  has  full  con- 
fidence in  its  ability  to  place  the  property  upon  a  substantial 
paying  basis,  provided  it  is  able  to  do  the  financing  always 
necessary  for  a  growing  property. 

"  Since  we  took  over  this  property  we  have  secured  a 
contract  with  the  city  in  which  the  Eapid  Transit  Company 
has  given  up  valuable  privileges  for  the  purpose  of  securing 
to  your  company  immunity  from  the  threat  of  hostile  legis- 
lation. This  contract  is  of  the  very  greatest  benefit  to  the 
Union  Traction  Company  and  its  underlying  lines. 

"  As  already  stated,  nearly  half  of  the  $40,000,000  capital 
raised  by  this  company  has  been  expended  directly  upon  the 
surface  system.  Several  millions  of  dollars  went  to  the 
building  of  what  are  practically  new  lines,  although  they 
have  been  built  under  extensions  of  your  old  charters,  princi- 
pally the  Twenty-second  Street  and  Allegheny  Avenue  Pas- 
senger Eailway  Company  in  which  you  own  every  share  of 
stock,  and  the  West  Philadelphia  Passenger  Railway  Com- 
pany (under  which  new  lines  have  been  built  on  52d,  58th, 
and  60th  streets)  in  which  your  company  owns  a  controlling 
interest. 


380  COKPOKATION   FINANCE 

"The  Eapid  Transit  Company  has  now  made  the  final 
call  upon  its  capital  stock  and  this  has  been  practically  ex- 
hausted by  the  expenditures  already  detailed.  It  is  now  nec- 
essary to  relay  many  miles  of  surface  track  and  to  add  equip- 
ment of  a  more  modern  character  calculated  to  serve  the 
public  better,  and  to  collect  a  much  greater  percentage  of 
the  fares.  These  expenditures  will  be  made  directly  upon 
your  property,  rendering  the  security  of  your  lease  that  much 
better,  both  as  to  the  value  of  the  property  and  its  earning 
power." 

It  appears  from  this  letter  that,  unless  the  Eapid  Transit 
Company  could  make  use  of  the  credit  of  the  Union  Traction 
Company,  the  financing  of  necessary  improvements  would 
be  impossible.  A  proposition  was,  therefore,  made  to  the 
stockholders  of  the  Union  Traction  Company  to  permit 
the  former  to  use  a  large  number  of  valuable  securities 
enumerated  in  the  list  and  intrusted  to  the  Eapid  Transit 
Company  as  collateral  security  for  an  issue  of  $5,000,000  of 
collateral  trust  bonds.  The  proposition  was  accepted  by  the 
Union  Traction  Company,  and  the  funds  provided.  Evi- 
dently, however,  the  lessee  company  cannot  always  count 
upon  the  acquiescence  of  stockholders  of  lessor  companies 
in  placing  encumbrances  upon  their  property  for  the  benefit 
of  that  property.  In  recent  leases,  provisions  have  been 
inserted  whereby  the  lessor  company  is  obliged,  under  cer- 
tain conditions,  to  finance  improvements  upon  its  own 
property. 

One  of  the  most  carefully  drawn  leases  ever  executed  is 
that  which  gave  to  the  Boston  Elevated  Eailway  Company 
the  control  of  the  West  End  Street  Eailway.  The  lease 
bound  the  Boston  Elevated  to  pay  seven  per  cent  per  annum 
on  the  common  and  eight  per  cent  on  the  preferred  stock 
directly  to  the  stockholders  without  any  reduction,  the  lease 
stating  that  these  dividends  were  to  be  "  net "  amounts.  The 
lease  further  explicitly  provided  that  the  Elevated  Company 
should  pay  all  damages  to  persons  or  property;  all  sums  due 


THE   LEASE  381 

for  taxes  —  federal,  state  or  municijml  —  upon  the  lessor's 
property,  franchise  or  capital  stock;  and  all  sums  "by  law 
required  to  be  deducted  from  any  amounts  payable  upon 
the  lessor's  stock."  The  lease,  on  the  other  hand,  stipulated 
that  all  saving  from  refunding  of  the  West  End  Company's 
bonus  should  accrue  to  the  lessee,  the  Boston  Elevated  Com- 
pany. The  lessee  also  assumed  definitely  the  interest  on  the 
bonds  of  the  West  End  Company,  and  on  the  existing  indeb- 
tedness of  any  street  railway  that  the  West  End  Company 
was  under  obligations  to  pay.  It  also  assumed  all  liabilities 
under  the  contract  with  the  city  of  Boston  touching  the 
subway. 

The  provisions  in  this  lease  regarding  the  right  of  the 
lessee  to  issue  stock  or  bonds  of  the  West  End  Company  for 
improvements,  particularly  deserve  attention.  The  West 
End  Company  was  required  to  issue  stock  or  bonds,  from  time 
to  time,  at  the  request  of  the  lessee,  in  order  to  meet  the 
cost  of  improvements  and  additions  to  the  lessor's  property. 
The  West  End  Company  must  be  informed  of  the  purposes 
for  which  it  is  proposed  to  issue  the  securities,  and  if  it 
dissent  from  the  expediency  of  the  expenditure,  and  with- 
holds its  consent  to  the  issue,  a  board  of  arbitrators  must 
pass  upon  the  matter.  If  the  arbitrators,  by  a  majority 
opinion,  do  not  approve  the  same,  the  lessee  cannot  insist 
upon  the  issue  being  made.  One  arbitrator  is  to  be  chosen 
by  each  of  the  parties  to  the  lease,  and  the  third  by  the 
two  so  chosen,  or  by  the  State  Board  of  Railroad  Commis- 
sioners, or  by  the  Chief  Justice  of  the  Supreme  Court  of 
Massachusetts.  The  lessee  company  has  the  right  to  decide 
whether  the  issue  of  security  by  the  lessor  shall  be  stock  or 
bonds,  and  it  may  fix  the  rate  of  interest  which  the  bonds 
shall  bear,  but  it  is  provided  that  "no  bond  shall  be  issued 
in  excess  of  the  outstanding  capital  stock "  of  the  lessor. 
This  reservation  in  the  lease  is  of  great  importance  to  both 
the  lessor  and  lessee.  It  enables  the  lessee  to  use  almost  at 
will  the  credit  of  the  lessor  for  the  purpose  of  improving 
property  out  of  which  it  may  be  making  a  large  profit. 


382  COKPOEATION   FINANCE 

It  is  true  that  the  lessor  is  protected  by  the  Arbitration 
Board,  bnt  still  further  safeguards  are  demanded.  There  is 
set  down  in  detail  in  the  lease  the  expenditures  which  the 
lessee  can  capitalize  for  the  account  of  the  West  End  Street 
Eailway.  These  are  especially  limited  to  the  following  per- 
manent additions  and  improvements: 

1.  The  abolition  of  grajde  crossing. 

2.  Additional  rolling  stock  and  equipment. 

3.  Additional  track  mileage  and  its  equipment. 

4.  Additional  real  estate. 

5.  Additional  stations,  power  and  car  houses.    . 

6.  Additional  buildings,  bridges  and  other  structures. 

7.  Eenewals  of  or  substitutes  for  stations,  bridges,  build- 
ings and  other  structures,  track  and  equipment,  "so  far  as 
the  cost  of  such  renewals  and  substitutions  exceeds  the  cost, 
when  new,  of  the  things  received  or  the  things  replaced." 

The  provision  just  described  is  now  often  included  in 
leases  of  properties  where  it  is  necesary  to  provide  for  cap- 
ital expenditures.  Another  method  sometimes  employed, 
and  which  a  proper  organization  of  the  capital  account  makes 
possible,  is  for  the  lessee,  when  it  takes  over  the  property 
of  the  lessor,  and  assumes  the  obligation  to  pay  interest  on 
its  bonds,  to  take  over  also  any  unissued  bonds  authorized 
imder  existing  mortgages,  and  to  issue  these  at  will  subject 
to  the  restrictions  of  the  mortgage.  This  method  is  prefer- 
able to  that  employed  in  the  Boston  lease  which  is  apt  to 
lead  to  endless  discussions  and  bickering  over  the  propriety 
of  particular  expenditures.  If  the  restrictions  in  the  mort- 
gage are  carefully  drawn,  the  lessee  can,  without  danger  to 
the  lessor's  property,  and  in  fact  with  great  benefit  to  the 
lessor,  freely  employ  the  credit  arranged  for  in  the  mortgage 
for  the  benefit  of  the  lessor's  property-  In  this  manner 
provision  can  be  made  for.  the  expansion  of  the  business 
carried  on  with  the  leased  property. 


CHAPTER    XXXI 
READJUSTMENT  OF  THE  CAPITAL  ACCOUNT 

The  capital  account  of  a  corporation  has  been  described 
as  a  statement  of  assets  and  liabilities.  From  time  to  time, 
it  becomes  necessary  or  advantageous  for  a  company  to  re- 
adjust its  capital  account,  changing  the  form  of  assets, 
exchanging  assets  for  liabilities,  distributing  assets  or  evi- 
dences of  liabilities  to  stockholders,  or  changing  the  form  of 
liabilities.  The  methods  employed  in  making  these  read- 
justments can  be  grouped  under  the  general  title  of  read- 
justment of  the  capital  account. 

Reorganization  of  the  capital  account  is  usually  required 
in  the  event  of  bankruptcy,  if  the  business  is  to  be  contin- 
ued. This  form  of  reorganization  will  be  considered,  in  a 
later  chapter.  <^>We  are  here  concerned  with  the  reorganiza- 
tion of  the  capital  accounts  of  solvent  companies. 

Reorganization  may  relate  either  to  assets  or  liabilities. 
The  first  condition  under  which  reorganization  may  be  nec- 
essary is  when  it  is  desired  to  change  the  form  of  assets. 
The  property  of  a  corporation  is  constantly  changing.  A 
railroad  company,  for  example,  may  wish  to  sell  a  part  of 
its  equipment  which  is  no  longer  suited  to  its  purposes,  or 
certain  real  estate  put  out  of  use  by  the  rearrangement  of 
a  terminal.  Similar  occasions  are  constantly  arising  when 
it  is  desirable  for  a  corporation  to  dispose  of  certain  of  its 
property.  When  securities  are  owned,  and  when  the  control 
over  the  companies  which  have  issued  these  securities  is  no 
longer  important  to  the  corporation  which  owns  them,  op- 
portunity sometimes  arises  .to  sell  these  securities,  and  to 
reinvest  the  proceeds,  either  in  improvements  or  in  other 


384  CORPORATION  FINANCE 

securities  showing  higher  rates  of  return.  The  testimony 
of  Mr.  E.  H.  Harriman  before  the  Interstate  Commerce  Com- 
mission in  its  investigation  of  the  alleged  illegal  combination 
between  the  Pacific  companies  in  1907,  explained  a  transac- 
tion of  this  character  as  follows: 

"  We  had,  as  the  result  of  the  Northern  Pacific  purchase, 
$82,000,000  of  Northern  Securities  stock,  at  a  cost  of  about 
$79,000,000.  Then  we  were  forced  by  the  decision  of  the 
Supreme  Court  to  take  Great  Northern,  which  we  did  not 
want,  and  a  lesser  amount  of  Northern  Pacific  than  we  had 
deposited  with  the  Northern  Securities  Company.  At  the 
time  the  Great  Northern  and  Northern  Pacific  was  forced 
upon  us,  it  had  a  market  value  of  about  $100,000,000.  .  .  . 
Instead  of  disposing  of  it  at  that  time,  we  held  it  until 
the  market  price  increased  in  value  to  somewhere  near 
$145,000,000  to  $150,000,000.  We  sold  some  of  it  grad- 
ually as  it  went  up,  but  at  that  value  the  returns  from  the 
Northern  Pacific  and  Great  Northern  were  less  than  three 
per  cent  on  the  stock  that  we  held.  Therefore  we  concluded 
that  it  was  better  to  sell  those  stocks  and  invest  the  same 
money  in  other  securities  that  would  give  us  greater  returns. 
So  that,  following  out  that  line,  we  have  sold  enough  of 
those  stocks  to  realize  $116,000,000." 

Mr.  Harriman  further  stated  that  the  income  from  the 
securities  purchased  was  approximately  $5,500,000,  instead  of 
$3,250,000  on  the  Great  Northern  and  Northern  Pacific 
stock. 

The  working  capital  of  •  a  company,^*  its.  casH^^  materials, 
and  bills  receivable,  varies  with  the  volume  of  its  business. 
It  is  offset,  in  part,  by  current  liabilities.  With  a  falling  off 
in  business,  a  part  of  this  working  capital  becomes  unneces- 
sary. It  may  then  be  employed  to  pay  off  the  current  d^bts/ 
of  the  company. 

In  some  cases  corporations  may  be  unable  to  meet  short 
term  indebtedness  at  maturity,  and  may  be  obliged  to  sacri- 


KEADJUSTMENT   OF   CAPITAL   ACCOUNT    385 

fice  some  of  their  property  to  take  up  their  loans.  The  Colo- 
rado Fuel  and  Iron  Company,  in  1903,  "  found  it  necessary, 
in  order  to  meet  its  obligations  under  contracts  previously 
made,  and  for  the  extensive  work  of  construction  and  bet- 
terments upon  which  the  company  entered  a  year  or  two  ago, 
and  also  for  its  general  corporate  purposes,  to  raise  money 
from  persons  interested  either  as  stockholders  or  directors, 
or  both,  by  means  of  loans  and  sales  (the  sales,  however,  being 
subject  to  a  contract  permitting  repurchase  by  the  Fuel  Com- 
pany within  a  specified  time)."  This  property  was  after- 
wards repurchased  by  the  corporation  at  an  advance  in  price, 
the  stockholders  being  allowed  to  participate  in  the  profits  of 
the  repurchase. 

The  disposition  of  assets  by  the  various  methods  above 
indicated  presents  no  difficulty  if  the  assets  are  not  pledged 
as  security  for  some  loan.  In  case  they  are  pledged,  how- 
ever, it  becomes  necessary  to  obtain  the  consent  of  the  trus- 
tee, whose  duty  it  is  to  make  sure  that  the  proceeds  of  the 
sale  are  used,  either  to  reduce  the  amount  of  bonds  secured 
by  the  mortgage  under  which  the  property  sold  was  pledged, 
or  reinvested  for  the  protection  of  the  bonds. 

Taking  up  next  the  readjustment  of  liabilities,  we  come 
first  upon  the  capital  stock.  The  increase  of  capital  stock 
as  a  means  of  distributing  the  surplus  has  already  been  re- 
ferred to  in  Chapter  XVIII.  We  are  concerned  with  the  con- 
ditions under  which  the  amount  of  capital  stock  may  be  re- 
duced. When  the  company  has  outstanding  an  amount  of 
stock  so  great  as  to  make  it  improbable  that  its  earnings  will 
ever  reach  a  point  where  dividends  can  be  safely  paid,  and 
especially  when  there  has  been  such  an  accumulation  of  unpaid 
dividends  on  preferred  stock  as  to  make  payment  of  dividends 
on  common  stock  highly  impracticable,  the  question  arises. 
Shall  the  capital  stock  be  reduced  to  a  dividend  paying  basis  ? 
When  the  value  of  the  stock,  because  of  the  remoteness  of 
dividend  payment,  has  fallen  to  a  nominal  figure,  this  ques- 
tion should  be  answered  in  the  affirmative.. 

A  company,  for  example,  with  $500,000  of  surplus  earn- 


386  COEPORATION   FINANCE 

ings  applicable  to  dividends  cannot,  as  a  rule,  safely  pay  out 
more  than  $300,000.  If  $250,000  of  this  $300,000  is  re- 
quired to  pay  preferred  dividends,  and  if  the  amount  of 
common  stock  is  $10,000,00a,  the  $50,000  remaining  equals 
only  one  half  of  one  per  cent  on  the  total  common  stock. 
There  may  also  be  accumulated  dividends  on  the  preferred 
stock,  making  the  payment  of  dividends  on  the  common  stock 
even  more  improbable.  Common  stock,  under  these  circum- 
stances, will  usually  sell  for  a  nominal  figure,  under  $5  a 
share.  Very  little  of  it  can  be  sold  at  any  price.  If,  how- 
ever, the  $10,000,000  of  common  stock  could  be  reduced  to 
$1,000,000,  and  the  accumulated  dividends  on  the  preferred 
stock  readjusted,  the  company  would  have  enough  surplus 
earnings  to  pay  five  per  cent  on  its  common  stock,  which 
might  be  expected  to  sell  at  from  $50  to  $60  a  share.  The 
proposition  made  to  the  common  stockholders  to  exchange, 
say,  ten  shares  of  the  old  stock  for  one  share  of  the  new 
stock  should  be  aceptable,  since  they  obtain  an  income  at 
once,  and  also  a  free  market  for  their  securities^  In  case 
the  increased  earnings,  of  the  company  eventually  make  it 
possible  to  pay  a  high  dividend  on  this  reduced  capital  stock, 
the  stock  retired  may  be  returned  to  the  stockholders  in  the 
form  of  stock  dividends,  maintaining  a  dividend  rate  at  a 
reasonable  figure,  and  placing  them  again  in  their  original 
position  so  far  as  concerns  the  par  value  of  their  holdings. 
This  method  was  employed  by  the  General  Electric  Company, 
which  in  1898  reduced  its  stock  40  per  cent  in  1902  return- 
ing the  amount  to  its  stockholders  in  a  special  dividend.  Sev- 
eral corporations  which  were  grossly  overcapitalized  at  the 
outset  have  reduced  their  capital  stocks  to  a  dividend  paying 
basis.  The  American  Malting  Company  and  the  Distillers' 
Securities  Company,  among  others,  have  made  such  reduction. 
Reduction  of  capital  stock  to  place  it  upon  a  dividend 
paying  basis  can  only  be  accomplished,  unless  the  company 
is  to  be  dissolved  and  its  property  taken  over  by  a  new  cor- 
poration, by  unanimous  consent  of  the  stockholders.  This 
unanimous  consent  is  comparatively  easy  to  obtain  when  the 


KEADJUSTMENT   OF   CAPITAL   ACCOUNT    387 

stock  has  only  a  nominal  value,  and  where  the  directors  are 
able  to  point  out  an  immediate  gain  to  the  stockholder  in 
taking  the  new  securities.  When,  however,  the  stock,  even 
though  nondividend  paying,  has  a  speculative  value  and  a 
free  market,  due  to  the  prevalence  of  rumors  concerning  its 
prospects  and  earnings,  or  to  reports  that  a  contest  for  its 
control  will  be  waged,  or  that  it  is  to  be  consolidated  with 
another  corporation,  it  is  then  practically  impossible  to  ob- 
tain the  consent  of  the  stockholders  to  reduce  the  value  of 
their  holdings  sufficiently  to  enable  the  immediate  payment 
of  dividends. 

Take,  for  example,  the  Erie.  This  company  has  out- 
standing $112,378,900  of  common  stock.  The  present  com- 
pany is  now  over  fifteen  years  old,  and  the  common  stock 
has  received  no  dividends.  During  the  last  fiscal  year,  the 
surplus  over  fixed  charges  was  barely  sufficient  to  pay  four 
per  cent  on  the  $63,892,400  of  preferred  stock,  which,  how- 
ever, received  nothing.  The  preceding  year  showed  a  deficit 
of  $2,199,226.  In  order  to  place  the  Erie  upon  a  dividend- 
paying  basis,  even  making  allowance  for  the  expected  im- 
provement in  its  earnings  due  to  the  reconstruction  of  its 
property  which  has  been  in  progress  for  some  years,  it  would 
require  a  reduction  of  the  common  stock  to  about  one  fifth 
of  its  present  amount,  to  enable  the  payment  of  a  moderate 
dividend  within  the  near  future.  And  yet  the  market  price 
of  the  Erie  is  to-day  (Aug.  29,  1910)  $25f  a  share,  and  even 
in  1908,  when  its  fortunes  were  at  the  lowest  ebb,  and  when 
a  receivership  was  anticipated,  the  lowest  figure  reached  by 
the  common  stock  was  $12  a  share.  To  reduce  the  common 
stock  of  the  Erie  from  $112,000,000  to  $30,000,000,  placing 
it  upon  a  four  per  cent  basis,  might  result  in  a  market  price 
of  $75  a  share.  A  proposition  to  reduce  this  stock  to  a  divi- 
dend paying  basis  would,  therefore,  be  equivalent  to  asking 
the  stockholders  of  the  Erie  to  surrender  about  $120  worth 
of  market  value  with  a  fair  prospect  of  higher  prices  in  the 
future,  in  return  for  four  per  cent  stock  which  might  be  sold 
for  $75  a  share.    If  the  Erie  stock  were  held  by  investors,  this 


388  CORPORATION  FINANCE 

proposition  might  be  acceptable,  but  since  such  stocks  are 
held  either  for  control  or  for  speculation,  it  would  be  impossi- 
ble to  secure  unanimous  consent  to  a  proposition  to  reduce  this 
amount. 

Illustrations  of  this  situation  are  furnished  by  the  Mis- 
souri, Kansas  &  Texas  which  earned  last  year  $420,000  on 
$63,300,000  of  common  stock,  but  which  sells  at  $42.50  a 
share  on  the  prospects  of  consolidation  with  some  other 
road,  and  the  Southern  Railway  which  showed  a  surplus  of 
$3,511,100  on  $120,000,000  of  common  stock  which  sells, 
however,  at  $27  a  share.  A  reduction  of  the  capital  stock  of 
small  corporations  whose  securities  have  no  speculative  value 
to  a  dividend  basis  is  feasible  and  desirable  since  it  stops  the 
accumulation  of  interest  on  the  cost  of  the  original  stock  to 
its  holders.  With  large  public  corporations,  however,  whose 
stock  contains  an  element  of  speculative  value,  this  method 
is  not  often  available. 

An  easier  method  of  favoring  the  common  stock  in  a  re- 
organization is  to  fund  accumulative  dividends  on  preferred 
stock.  Suppose  a  case  like  the  following:  A  company  issues 
$5,000,000  of  preferred  stock  and  $5,000,000  of  common 
stock.  The  preferred  stock  carries  seven  per  cent  of  cumu- 
lative dividends,  and  thirty-five  per  cent  of  unpaid  dividends 
stand  against  the  common  stock.  The  company  earns  $500,- 
000  a  year  net  over  charges,  sufficient  to  pay  the  current  divi- 
dends on  the  preferred,  and  leave  $150,000  to  be  applied  to 
the  accumulated  dividends.  At  this  rate  it  will  require  eleven 
years  to  pay  the  accumulated  dividends,  during  which  time 
the  common  stock  will  receive  nothing.  A  proposition  is 
made  to  the  preferred  and  common  stockholders  that  the 
company  shall  issue  five  per  cent  debenture  bonds  or  five 
per  cent  second  preferred  stock  in  exchange  for  these  back 
dividends  which  amount,  as  already  stated,  to  about  $1,750,- 
000  on  $5,000,000.  The  debentures  should  sell,  on  the  com- 
pany's showing  of  surplus  earnings,  at  about  80.  The  fixed 
charges  of  the  corporation  would  be  increased  by  the  issue 
$87,500  per  year. 


KEADJUSTMENT   OF   CAPITAL  ACCOUNT    389 

This  proposition  would  appeal  to  the  two  classes  of  stock- 
holders as  follows:  The  preferred  stockholder  receives,  in- 
stead of  a  contingent  right  to  $1,750,000  of  dividends,  that 
amount  par  value  of  debenture  bonds  with  a  market  value 
of  $1,400,000.  There  is  little  doubt  that  the  preferred  stock- 
holder would  accept  a  proposition  so  favorable.  The  com- 
mon stockholder  is  equally  advantaged  by  such  a  plan.  The 
earnings  available  for  the  common  stock,  after  adding  $87,- 
500  to  the  fixed  charges  of  the  company,  are  $262,500,  or 
five  and  two  tenths  per  cent  on  the  par  value  of  the  stock, 
out  of  which  three  per  cent  can  be  safely  paid.  Without  any 
reduction  of  the  par  value  of  his  security,  the  common  stock- 
holder at  once  receives  an  income.  Such  a  case  as  this  is, 
however,  seldom  encountered.  Preferred  dividends,  when 
cumulative,  are  usually  paid,  even  at  the  sacrifice  of  the 
permanent  interest  of  the  corporation.-  There  are  few  cases 
of  accumulation  so  great  as  to  seriously  depreciate  the  value 
of  the  common  stock,  and  when  this  has  occurred,  as  in  the 
Republic  Iron  and  Steel  Company,  and  the  Crucible  Steel 
Company,  earnings  have  usually  recovered  so  as  to  permit  the 
discharge  of  these  back  dividends  without  any  scheme  of  re- 
organization. Wherever  preferred  dividends  are  allowed 
to  accumulate  to  unmanageable  proportions,  however,  the 
method  above  outlined  will  be  found  in  most  cases  desir- 
able. ^ 

Stock  may  also  be  reduced  by  exchanging  into  bonds  with 
the  consent  of  the  statutory  proportion  of  the  stock.  This 
method  is  applicable  to  seven  and  eight  per  cent  preferred 
stocks  issued  by  companies  which  are  later  able  to  place 
junior  issues  of  bonds  at  fair  prices.  The  most  notable  in- 
stance of  such  a  conversion  is  that  of  the  United  States  Steel 
Corporations  bond  conversion  in  1902.  On  April  17,  1902, 
the  president  of  the  United  States  Steel  Corporation  issued 
a  circular  to  the  stockholders,  which  invited  their  coopera- 
tion in  a  plan  to  raise  $50,000,000  of  new  capital.  Half  of 
this  amount  was  to  repay  loans  incurred  by  the  constituent 
companies  for  construction  work  which  was,  in  part,  ren- 
26 


390  COKPOKATION   FINANCE 

dered  unnecessary  by  the  merger,  but  which,  owing  to  ad- 
vance commitments,  could  not  be  suspended.  In  addition, 
$25,000,000  was  required  for  improvements,  which,  it  was 
stated,  would  effect  an  annual  saving  of  at  least  $10,000,000. 
The  plan  proposed  to  the  stockholders  for  raising  this  money 
was  "to  rearrange  your  corporation's  capitalization  (which, 
in  round  numbers,  now  consists  of  $300,000,000  of  bonds, 
$500,000,000  of  preferred  stock,  and  $500,000,000  of  com- 
mon stock)  by  substituting  for  $200,000,000  of  the  preferred 
stock,  $200,000,000  of  sinking  fund  sixty-year  five-per-cent 
mortgage  gold  bonds,  and  by  selling  $50,000,000  of  addi- 
tional bonds  of  such  issue  for  cash.  As  the  preferred  car- 
ries seven  per  cent  dividends,  while  the  bonds  would  bear 
but  five  per  cent  interest,  the  $50,000,000  desired  could,  in 
this  way,  be  added  to  the  corporate  resources,  and  the  aggre- 
gate of  the  annual  charges  for  interest  and  dividends,  in- 
stead of  being  increased  $3,500,000,  would  be  decreased  $1,- 
500,000  as  compared  with  the  present  sum  total  of  these  two 
requirements." 

The  plan  offered  to  each  preferred  stockholder  the  right 
to  subscribe  to  the  new  bonds  to  the  extent  of  one  half  his 
holdings  of  preferred  stock,  forty  per  cent  of  each  subscrip- 
tion to  be  payable  in  preferred  stock,  and  ten  per  cent  in 
cash,  or  the  subscription  could  be  limited  to  forty  per  cent, 
in  which  event  no  cash  payment  was  required.  This  transac- 
tion was  assailed  in  the  courts,  and  was  delayed  for  a  long 
period  by  injunctions.  It  was  finally  abandoned  after  $150,- 
000,000  of  preferred  stock  had  been  converted.  Conversion 
of  stock  into  bonds  such  as  this  plan  provided,  can  only  be 
justified  when  the  company  making  the  conversion  is  so 
strong  in  surplus  earnings  that  the  issue  of  the  new  bonds 
will  not  jeopardize  its  solvency.  Given  this  assurance,  the 
advantage  to  the  common  stockholder  is  in  the  reduction  of 
the  payments  which  must  precede  his  dividends,  from  the 
rate  on  the  preferred  stock  to  the  rate  of  interest  on  the 
bonds  issued  in  exchange: 

We  next  take  up  the  readjustment  of  the  debt  liabilities 


EEADJUSTMENT   OF   CAPITAL   ACCOUNT    391 

of  the  company,  dividing  these  into  current  liabilities,  short 
term  notes,  and  long  term  bonds.  Current  liabilities,  when 
they  exceed  the  normal  amount  in  a  particular  industry, 
must  be  paid,  either  by  the  sale  of  some  of  the  assets, 
or  by  the  sale  of  bonds  or  notes.  The  methods  of  hand- 
ling short  term  notes  have  already  been  discussed  in  Chap- 
ter XXIII. 

When  these  are  issued  on  the  security  of  collateral,  if  a 
favorable  opportunity  arises  to  sell  the  collateral,  provision  is 
usually  made  for  its  retirement  before  maturity.  When 
they  mature,  the  method  employed  is  either  to  sell  the  bond 
collateral  and  so  obtain  the  means  of  payment,  or  to  extend 
the  notes,  or  to  issue  a  new  series  of  notes,  or  to  take  up 
the  notes  with  an  issue  of  stock.  In  most  extension  agree- 
ments, inducements  are  offered,  usually  in  the  form  of  higher 
rates  of  interest,  or  better  security  on  the  new  issue.  A 
syndicate  may  be  organized  to  purchase  the  securities  which 
are  to  be  issued  to  take  up  those  maturing,  and  then  to  offer 
to  the  holders  of  the  maturing  obligations  the  right  to  take 
the  new  securities  on  a  favorable  basis.  The  ordinary  induce- 
ment is  a  cash  premium. 

The  method  of  carrying  through  such  a  transaction  is 
shown  by  the  refunding  of  the  $6,000,000  of  four  and  one  half 
per  cent  collateral  trust  notes  issued  by  the  Chicago,  Rock 
Island  &  Pacific  Railway  Company  in  1906.  When  these  ma- 
tured in  April,  1908,  the  bond  market  was  not  in  a  condition 
to  justify  the  offering  of  a  long  term  security.  The  company, 
therefore,  notified  the  note  holders  that  it  had  arranged  with 
Speyer  &  Company  for  the  extension  of  these  notes  for  one 
year,  with  interest  at  six  per  cent,  subject  to  redemption  at 
the  option  of  the  company  on  sixty  days'  notice.  It  was  stated 
that  "  Holders  who  desire  to  extend  their  notes  must  present 
them,  the  April  1st  coupon,  at  the  office  of  Speyer  &  Company, 
on  or  before  March  23d.  A  cash  payment  of  $5  on  each  $1,000 
note  extended  will  be  made  to  the  holders  availing  themselves 
of  this  offer.  Holders  who  do  not  desire  to  extend  will  receive 
par  for  their  notes  on  April  1." 


392  COEPOKATION  FINANCE 

Speyer  &  Company  had  arranged  with  the  Eailway  Com- 
pany to  purchase  such  an  amount  of  the  new  notes  as  were 
not  taken  by  the  holders.  The  six  per  cent  notes  were  of- 
fered at  99.5,  yielding  6 J  per  cent  per  annum,  so  it  is  fair 
to  presume  that  Speyer  &  Company  did  not  pay  over  95  or 
96.  The  more  advantageous  the  extension  offer  is  made,  the 
easier  will  be  the  terms  that  can  be  arranged  with  the  syndi- 
cate, since  every  note  replaced  with  a  new  note  lessens  the 
financial  liability  of  the  bankers. 

A  special  method  of  funding  floating  debt,  which  has 
been  used  for  the  relief  of  embarrassed  companies,  is  the 
funding  or  deposit  of  interest  coupons.  This  may  be  ac- 
complished by  several  methods:  arrangements  may  be  made 
with  a  syndicate  to  purchase  the  amount  of  coupons  which 
it  may  be  impossible  for  the  corporation  to  pay,  taking  the 
corporation's  bonds  as  security,  or  the  bondholders  may  be 
asked  to  take  stock  or  bonds  in  lieu  of  their  coupons,  or 
they  may  be  asked  to  deposit  their  coupons  with  some  des- 
ignated agent  or  trustee,  foregoing  their  claim  for  inter- 
est during  the  period.  The  first  plan  of  funding  cou- 
pons is  illustrated  by  the  following  announcement  to  cer- 
tain bondholders  of  the  Erie  by  President  Underwood  on 
June  11,  1908: 

To  the  Holders  of  Prior  Lien  Bonds  and  General  Lien  Bonds 
Under  the  First  Consolidated  Mortgage: 

"The  extraordinary  business  depression,  which  has 
seriously  affected  all  the  railroads  throughout  the  United 
States,  has  so  reduced  the  net  earnings  of  the  Erie  Eailroad 
that  there  will  be  a  deficit  below  the  amount  necessary  to 
meet  fixed  charges  for  the  current  fiscal  year  ending  June 
30,  1908.  While  it  is  confidently  expected  that  with  any 
return  to  normal  business  conditions  this  deficit  will 
promptly  be  made  good,  it  is  necessary  for  the  company 
temporarily  to  obtain  the  amount  from  other  sources. 

"  To  this  end,  among  other  things,  it  has  been  arranged 
that  the  coupon  for  interest  falling  due  at  any  time  prior 


EEADJUSTMENT   OF   CAPITAL  ACCOUNT    393 

to  July  1,  1909,  may  be  purchased  for  cash  and,  with  unim- 
paired lien,  deposited  and  pledged  under  the  collateral  in- 
denture of  April  8,  1908,  as  additional  security  for  the  six 
per  cent  collateral  gold  notes  issued  and  to  be  issued  there- 
under, thus  making  the  notes  more  available  to  the  company 
as  a  means  of  obtaining  further  cash  if  required,  such  notes 
to  be  accepted  at  par  by  the  purchasers  of  the  coupons  for  the 
amounts  advanced  for  such  purchase.  While  such  temporary 
relief  will  probably  suffice  for  the  maintenance  and  opera- 
tion of  the  property  during  the  current  calendar  year,  it  will 
not  be  sufficient  for  the  completion  of  the  improvements  be- 
gun two  years  ago,  but  which  have  not  yet  reached  a  condition 
where  they  are  available  for  producing  additional  revenue 
for  the  company. 

"  It  was  anticipated  that  the  funds  for  such  improve- 
ments could  be  provided  from  the  sale  of  your  company's 
general  mortgage  bonds,  but,  principally  owing  to  the  injury 
done  to  your  company's  credit  by  the  falling  off  in  earnings 
during  the  existing  business  depression,  such  bonds  are  not 
now  salable,  except  at  prohibitive  prices. 

"As  these  improvements  all  serve  to  strengthen  the 
security  of  the  prior  lien  and  the  general  mortgage  bonds, 
it  is  expected  that  a  plan  will  shortly  be  prepared  for  fund- 
ing the  coupons  maturing  on  these  bonds  for  a  period  suf- 
ficiently long  to  enable  the  company,  out  of  its  current 
funds,  to  complete  the  improvements  now  under  way, 
and  thus  get  the  benefit  of  the  large  expenditures  al- 
ready made,  but  which,  as  above  stated,  remain  as  yet  un- 
productive. 

"You  are  therefore  notified  that  your  coupons,  falling 
due  July  1,  1908,  will  be  purchased  at  par  for  cash  by  J.  P. 
Morgan  &  Company,  upon  presentation  and  surrender 
thereof,  on  or  before  June  30,  1908,  at  their  office,  No.  23 
Wall  Street,  New  York." 

The  foregoing  plan  involved  the  sale  to  a  syndicate  of  a 
sufficient  amount  of  the  collateral  trust  notes  of  the  company 


394  COKPOEATION   FINANCE 

to  take  up  maturing  coupons.  The  coupons  so  purchased, 
aggregating  $3,160,480,  were  to  be  pledged  under  the  inden- 
ture of  the  collateral  trust  notes,  and  the  bankers  accepted 
for  their  advances  an  equal  face  value  out  of  $4,500,000  of 
the  $15,000,000  note  issue  of  1908  which  had  been  reserved. 
When  these  notes  were  paid,  the  liability  of  the  company,  on 
account  of  these  coupons,  lapsed. 

This  relief  to  the  finances  of  the  Erie  was  not  considered 
sufficient,  and  a  further  proposition  was  made  to  the  bond- 
holders, that  they  should  accept  bonds  of  the  company, 
instead  of  cash,  for  the  coupons.  This  proposition,  as  finally 
approved  by  the  Public  Service  Commission  for  the  Second 
District  of  New  York,  was  as  follows:  The  company  was 
to  issue  $30,000,000  par  value  of  collateral  trust  thirty  year 
five  per  cent  bonds  secured  by  general  mortgage  bonds  which 
had  been  authorized  but  which,  as  the  statement  of  Presi- 
dent Underwood  shows,  could  not  be  sold  at  reasonable  prices. 
These  bonds  were  to  be  exchanged  for  coupons  on  the  gen- 
eral lien  and  convertible  four  per  cent  bonds  up  to  the 
amount  of  $11,380,000,  on  the  basis  of  par  value  of  bonds  for 
the  face  value  of  the  coupons.  The  company,  on  its  part, 
agreed  to  expend  from  income  every  six  months,  for  im- 
provements and  additions  to  the  property,  an  amount 
equal  to  the  interest  so  funded  which  had  accrued  during 
the  six  months,  this  arrangement  to  continue  for  the  five 
years  during  which  the  funding  of  coupons  was  to  go  for- 
ward. The  advantages  of  this  arrangement  to  the  company 
and  to  the  holders  of  these  junior  mortgage  bonds  were  as 
follows : 

The  company  was  relieved  of  the  necessity  of  paying 
interest,  which  at  that  time  was  not  being  earned,  and  was 
assured  of  $11,380,000  of  new  capital  within  five  years  on 
which  it  paid  five  per  cent  interest.  The  refunding  scheme 
did  not  relieve  it  from  the  obligation  of  providing  the  money 
necessary  to  pay  the  interest  on  these  junior  lien  bonds,  but 
enabled  it  to  apply  this  money  to  the  improvement  of  the 
property.    To  the  bondholder  the  advantages  of  the  reorgani- 


EEADJUSTMENT    OF   CAPITAL  ACCOUNT    395 

zation  were  even  more  apparent.     They  were  set  forth  in  a 
statement  issued  on  behalf  of  the  company  as  follows : 

"We  have  put  into  the  property  in  the  last  few  years 
upward  of  $16,000,000  that  has  not  been  capitalized — 
$8,154,381  charged  against  income  and  $8,345,829  charged 
to  capital  account,  and  not  yet  represented  by  any  bonds.  In 
seeking  to  capitalize  these  expenditures,  we  are  asking  the 
assistance  of  our  bondholders  instead  of  outside  investors,  be- 
lieving that  we  can  get  such  assistance  from  the  bondholders 
on  much  more  favorable  terms.  As  you  will  notice,  the 
coupons  are  to  be  exchanged  for  the  new  bonds  at  par,  where- 
as on  the  balance  of  the  issue  not  consumed  by  the  funding 
of  the  coupons  or  the  refunding  of  the  three  year  notes,  the 
Public  Service  Commission  fixes  a  net  price  to  the  company 
of  87i. 

"  We  have,  awaiting  completion,  on  the  Erie  &  Jersey 
Railroad  and  the  Genesee  River  Railroad  lines  and  others, 
important  improvements  in  the  shape  of  cut-off  and  low-grade 
lines  into  which  we  have  put  millions  of  money.  We  are  not 
yet  in  a  position  to  reap  the  benefit  of  these  improvements 
because  it  will  require  several  millions  to  complete  them,  and 
we  do  not  feel  that  we  can  take  the  amount  necessary  to 
complete  them  from  operating  income.  Therefore  we  are 
undertaking  to  defer  the  interest  on  the  general  lien  and  the 
convertible  four  per  cent  bonds  and  to  put  the  equivalent 
amount  into  the  completion  of  the  improvements  in  question, 
so  that  at  the  end  of  the  five  years,  the  road  will  be  in  a 
position  to  take  up  all  its  obligations  and  operate  at  a 
profit. 

"  There  is  hardly  any  question  as  to  our  ability  to  do  this. 
In  every  year  from  the  •  reorganization  until  last  year  the 
Erie  showed  a  surplus,  including  coal  properties,  of  from  $4,- 
000,000  to  $7,000,000  over  its  fixed  charges.  Last  year,  on 
account  of  the  extraordinary  conditions,  there  was  a  deficit, 
but  the  first  six  months  of  the  current  fiscal  year  show  a 
surplus  from  operation,  and  when  the  revenues  from  its  coal 


396  COKPOKATION  FINANCE 

are  taken  in,  there  is  a  surplus  of  $2,000,000  for  the  six 
months.  This  is  after  all  the  interest  has  been  paid,  includ- 
ing that  which  it  is  now  proposed  to  defer,  so  that  I  do  not 
think  there  is  any  reasonable  possibility  of  our  being  unable 
to  put  the  required  amount  into  the  property  out  of  income 
from  year  to  year." 

If  the  Erie  did  not  obtain  new  capital,  it  must  abandon 
improvements  on  which  a  large  amount  of  money  had  already 
been  expended  and  which  were  as  yet  unproductive.  Un- 
less this  work  could  be  carried  through,  the  prospects  of 
the  company  were  gloomy.  With  the  new  capital,  however, 
there  was  every  reason  to  believe  that  the  Erie  could  be 
placed  on  a  basis  of  assured  solvency,  and  that  no  such  des- 
perate remedies  as  that  explained  in  the  announcement  of 
President  Underwood  would  in  fact  be  necessary.  The  bond- 
holders were  not  asked  to  forego  their  interest.  They  were 
merely  invited  to  invest  their  interest  in  the  five  per  cent 
bonds  of  the  company,  which  would  be  well  secured  and 
marketable  at  a  price  near  par.  The  plan  of  the  Erie  for  the 
funding  of  coupons  was  unusually  favorable  to  the  bondhold- 
ers. They  were  to  receive  their  interest  in  the  form  of  salable 
bonds,  but  were  assured  that  the  amount  of  the  interest 
would  be  invested  in  the  property.  It  was  not  found  nec- 
essary to  put  this  plan  into  operation,  owing  to  the  im- 
provement in  the  bond  market,  which  enabled  the  Erie  to 
obtain  the  necessary  money  by  selling  its  bonds  as  originally 
contemplated. 

In  most  cases,  the  bondholders  do  not  receive  so  much 
consideration,  the  alternative  being  presented  to  them  of 
either  depositing  their  coupons  and  foregoing,  for  a  time, 
their  claim  to  interest,  or  taking  the  chances  of  bankruptcy. 
In  return  for  the  deposited  coupons,  the  company  may  issue 
negotiable  receipts.  The  usual  method,  however,  is  a  simple 
postponing  of  interest  without  equivalent.  The  first  method 
is  illustrated  by  the  plan  for  funding  the  coupons  due  from 
August  1,  1908,  to  February  1,  1912,  on  the  first  mortgage 
bonds  of  the  Hudson  River  Electric  Power  Company.    This 


KEADJUSTMENT   OF   CAPITAL  ACCOUNT    397 

contemplates  the  issue  of  $4,000,000  collateral  coupon  notes 
in  exchange  for  the  coupons  dollar  for  dollar :  "  In  case  of 
default  for  thirty  days  in  payment  of  interest,  then  so  much 
of  the  principal  of  the  notes  as  is  represented  by  deposited 
coupons  whose  dates  of  maturity  shall  have  been  reached, 
shall,  at  the  election  of  the  trustee,  upon  the  request  of  the 
holders  of  sixty  per  cent  of  the  outstanding  notes,  become 
immediately  due  and  payable.  And  in  case  of  thirty  days 
default  in  the  payment  of  any  portion  of  the  principal  of 
the  notes,  the  trustee  shall,  upon  demand,  restore  to  the  re- 
spective holders  the  coupons  uncanceled."  The  deposit  of 
coupons  without  a  return  from  the  company  is  illustrated  by 
the  action  of  the  bondholders  of  the  Deschutes  (Oregon) 
Irrigation  Company  who  unanimously  agreed  on  February 
10,  1908,  to  surrender  to  a  committee  of  the  bondholders 
the  coupon  due  March  1,  1908,  and  also,  if  the  committee 
so  requested,  the  coupon  due  September  1,  1908.  The  com- 
pany was  expected  eventually  to  pay  these  coupons  with  inter- 
est at  six  per  cent,  but  in  the  failure  to  do  so,  or  in  the 
event  of  a  receivership,  the  bonds  themselves  were  to  be  de- 
posited with  the  committee.  Here  is  a  postponement  of 
interest  for  the  benefit  of  a  temporarily  embarrassed  cor- 
poration. Action  such  as  the  foregoing  is  prudent.  The 
bondholders  do  not  care  to  take  over  the  property  with  the 
responsibilities  of  its  management.  The  expenses  of  receiver- 
ship and  reorganization  might  subject  them  to  heavy  losses. 
When  they  can  be  readily  reached,  and  the  proposition 
clearly  presented  to  them,  it  should  not  be  difficult  to  per- 
suade bondholders  to  defer  their  demands  for  interest,  in 
order  that  the  company  may  bridge  over  a  temporary  em- 
barrassment. 

Taking  up  now  the  readjustment  of  long  term  bonds,  we 
have,  first,  the  conversion  of  bonds  into  stock;  this  has  been 
already  fully  discussed  under  the  head  of  convertible  bonds. 
In  Chapter  XXIV  it  was  shown  that  the  advantage  to  the 
company  in  using  convertible  bonds  which  were  eventually 
exchanged  for  stock  was,  in  effect,  the  sale  of  stock  at  a 


398  COEPOKATION   FINANCE 

higher  price  than  could  have  been  obtained  for  the  stock  in 
the  market  and  also,  upon  conversion,  a  reduction  of  its  fixed 
charges  and  a  resulting  improvement  of  its  credit.  The  ad- 
vantage to  the  stockholder  is  an  opportunity  for  a  speculative 
profit,  or  to  exchange  his  four  or  five  per  cent  security,  for 
a  stock  whose  dividends  may  rise  to  such  an  amount  as  to  show 
him  a  large  yield  on  his  investment. 

The  usual  adjustment  necessary  in  long  term  bonds  is 
the  conversion  of  one  issue  into  another.  We  have  already 
discussed  at  some  length  (in  Chapter  VII)  the  general  in- 
expediency of  providing  for  the  payment  in  cash  of  bonds 
at  maturity.  Such  provision  can  only  be  made  by  the  ac- 
cumulation of  a  fund  in  interest-bearing  securities,  or  to  pay 
off  the  debt,  during  its  life,  by  installments,  out  of  the  in- 
come. Since  a  growing  corporation  is  continually  in  need 
of  money  for  improvements,  and  since  the  return  on  such 
expenditures  is  usually  far  greater  than  the  return  on  any 
securities  which  could  be  purchased  for  the  sinking  fund, 
it  is  for  the  interest  of  the  company,  instead  of  accumulat- 
ing a  sinking  fund  in  bonds,  to  spend  the  equivalent  of  the 
sinking  fund  on  its  property.  Such  a  policy,  however,  makes 
no  special  provision  for  the  repayment  of  bonds  at  maturity. 
Its  object  is  to  make  the  corporation  so  strong  in  assets  and 
earnings  that  when  its  bonds  mature,  there  will  be  no  dif- 
ficulty in  placing  a  new  issue  which  can  either  be  exchanged 
directly  for  the  maturing  bonds,  or  can  be  sold  for  cash  for 
an  amount  sufficient  to  pay  off  those  bonds  whose  holders 
wish  to  change  their  investment. 

An  additional  reason  for  refunding  bonds,  instead  of 
accumulating  a  sinking  fund  to  pay  them,  is  found  in  the 
fact  that  new  enterprises  usually  pay  high  rates  of  interest, 
owing  to  the  limited  demand  for  such  unseasoned  secur- 
ities. If  the  corporation  succeeds,  its  credit  will  im- 
prove to  the  point  of  placing  bonds  at  much  lower  rates. 
When  bonds  mature,  a  considerable  saving  can  therefore 
be  made  by  taking  them  up  with  other  bonds  bearing  low 
rates. 


EEADJUSTMENT   OF   CAPITAL  ACCOUNT    399 

Eefunding  of  bonds  may  take  place  either  before  the 
bonds  mature,  or  at  maturity.  If  bonds  are  issued  subject 
to  call  at  a  fixed  price,  no  difficulty  is  presented  in  retiring 
them.  If,  for  example,  a  corporation  issues  $1,000,000  of 
six  per  cent  bonds  at  90,  callable  at  105  after  three  years, 
and  if  its  credit  improves  to  the  point  of  selling  a  five  per 
cent  bond  at  95,  it  is  profitable  for  the  company  to  call  the 
six  per  cent  bonds,  replacing  them  with  an  issue  of  5s.  The 
economy  of  the  transaction  can  be  represented  as  follows: 

Amount  of  five  per  cent  bonds  at  ninety-five  re- 
quired to  produce  $1,050,000 $1,105,262 

Interest  at  five  per  cent  on  these  bonds 55,263 

Interest  on  the  six  per  cent  bonds  which  are  retired,         60,000 
Annual  saving 4,737 

Conversion  before  maturity  is  sometimes  made  in  order 
to  provide  for  new  financing  with  first  mortgage  bonds  with- 
out the  provision  in  the  mortgage  that  these  bonds  can  be 
issued  for  securities  purchased.  The  opportunity  may  arise 
for  acquiring  control  of  desired  properties,  by  exchanging 
bonds  which  carry  stock  control  with  them.  The  bonds  out- 
standing under  the  first  mortgage,  however,  present  an  ob- 
stacle to  this  transaction.  In  such  a  case,  the  bonds  could 
be  called  and  replaced  with  a  new  issue  secured  by  a  mortgage 
containing  the  desired  provision.  When  such  a  conversion 
is  contemplated,  the  cost  can  be  greatly  reduced  if  a  large 
amount  of  the  bonds,  whose  holders  are  not  entitled  tt)  infor- 
mation concerning  the  intention  of  the  buyers,  can  be  pur- 
chased at  the  regular  market  price.  The  five  per  cent  bonds, 
for  example,  which  might  be  callable  at  105  would  not  sell 
for  more  than  95.  In  anticipation  of  the  conversion,  ar- 
rangements could  be  made  with  the  house  which  placed  the 
bonds  to  accumulate  as  many  as  possible,  in  the  interest  of 
the  corporation,  at  the  market  price.  In  this  way,  the  pre- 
mium need  only  be  paid  on  those  bonds  which  it  is  impossible 
to  secure. 

When  bonds  are  not  callable  before  maturity,  and  if  they 
cannot  be  purchased  at  reasonable  prices  in  the  interest  of 


400  COKPOKATION   EINANCE 

the  company,  certain  inducements  must  be  offered  to  the 
holder.  These  may  take  the  form  either  of  better  security 
on  the  new  bonds,  or  a  higher  market  value  in  the  new  bonds 
than  those  which  are  retired,  or  a  bonus  of  cash  or  stock. 
An  illustration  of  the  method  of  accomplishing  such  a  refund- 
ing is  furnished  by  the  readjustment  of  the  bonded  debt  of 
the  St.  Louis  &  San  Erancisco  in  1901.  It  was  proposed  to 
take  up  thirteen  underlying  issues  secured,  for  the  most 
part,  by  first  mortgages  on  certain  portions  of  the  company's 
property,  by  issuing  a  refunding  fifty-year  mortgage  bond, 
of  which  $62,500,000  were  reserved  for  refunding  purposes. 
By  unifying  the  indebtedness  of  the  sytem,  the  company  not 
only  reduced  interest  charges,  but  was  also  enabled  to  finance 
additions  by  selling  bonds  having  an  established  market 
value.  A  syndicate  was  formed  under  the  management  of 
J.  &  W.  Seligman,  which  agreed  to  purchase  for  refunding 
purposes  $30,000,000  face  value  of  the  refunding  mortgage 
bonds.  The  syndicate  then  made  the  following  offer  to  the 
holders  of  the  underlying  bonds: 

'To  Holders  of  the  Following  Underlying  Bonds: 

"  As  Syndicate  Managers  of  a  syndicate  formed  under  an 
agreement  dated  April  4,  1901,  we  have  arranged  with  the 
St.  Louis  &  San  Erancisco  Railroad  Company  to  purchase, 
for  refunding  purposes,  $30,000,000,  face  value  of  its  pro- 
posed Refunding  Mortgage  Gold  Bonds,  to  bear  interest  at 
the  rate  of  four  per  cent  per  annum,  and  hereby  offer  to 
exchange  such  refunding  bonds  (to  the  extent  to  which  they 
may  be  so  issued  and  acquired  by  the  syndicate),  for  under- 
lying bonds  of  the  railroad  company's  system,  on  the  fol- 
lowing basis: 


EEADJUSTMENT   OF   CAPITAL   ACCOUNT     401 


For  Each  $1,000  Face  Value  of 

THE  Following  Outstanding 

Bonds 

In  Refund- 
ing Bonds, 
Face 

Value 

Cash 

Market 

Price 
(Added) 

1.  6%  Second    Mortgage   A, 

B  and  C  Bonds 

2.  6%  Missouri   &   Western 

Division    First    Mort- 
gage Bonds 

$1,166.66 

1,282.05 
1,282.05 

1,369.23 

1,194.87 
1,179.49 

113iandint. 

125     "      " 
125     "      " 

133i    "      " 

116^    "      " 
115     "      " 

Range  on 
June  8.  1901 

112-114J 

3.  6%  Trust  Bonds  of  1880 . . 

4.  6%  General         Mortgage 

Bonds 

134-135} 

5.  5%  General         Mortgage 
Bonds 

118-118i 

6.  5%  Trust  Bonds  of  1887 . . 

7.  6%  St.  Louis,  Wichita  & 

Western    First    Mort- 

102^-112 

gage     Redeemable 
Bonds. .  . 

1,179.49 

1,128.20 
1,025.64 
1,051.28 
1,000.00 
876.93 

1,051.28 

974.35 
1,025.64 

115      "      " 

. 110     "      " 

100     "      " 

102J    "      " 

97i    "      " 

85i    "      " 

102J    "      " 

95     "      " 
100     "      " 

8.  6%  Fort    Smith    &    Van 
Buren      Bridge     First 
Mortgage    bonds     (re- 
deemable) .  . . 

9.  5%  Southwestern  Division 
Bonds  (redeemable) . 

10.  4%  Central           Division 

Bonds  (redeemable) . .  . 

11.  4%  Kansas  City  Division 

Bonds  (redeemable) . .  . 

12.  3%  Kansas  City  Division 

Bonds  (redeemable) . .  . 

13.  4%  Northwestern      Divi- 

sion   Bonds     (redeem- 
able)   

14.  4%  Red    River    Division 
Bonds 

15.  4%  Consolidated  Bonds.  . 

"  At  the  time  of  deposit,  holders  of  underlying  bonds  will 
receive  payment  in  cash  of  the  unmatured  interest  accrued 
and  accruing  upon  their  deposited  bonds  to  July  1,  1901, 
from  which  date  the  refunding  bonds  are  to  bear  interest." 

A  comparison  of  these  two  tables  with  the  third,  giving 
the  current  market  quotation  of  the  more  important  of  these 
underlying  bonds,  shows  the  advantage  to  the  holders  of  ac- 
cepting the  syndicate's  offer.    The  price  offered  was,  in  every 


402  CORPOKATION   FINANCE 

case,  higher  than  the  current  market  quotation.  Further- 
more, the  bondholders  received  in  exchange  for  bonds  in- 
cluded in  various  small  issues,  the  bonds  of  a  large  issue  which 
they  could  readily  market,  and  which  would  be  accepted  by 
banks  as  collateral  security  to  a  high  percentage  of  their  par 
value.  These  bonds  were  offered  on  an  exchange  basis,  at 
prices  which  were,  on  the  whole,  more  favorable  than  could 
have  been  secured  in  the  market.  The  offer  in  cash  was 
slightly  below  the  offer  in  bonds,  and  the  only  question  which 
could  arise  in  the  minds  of  the  holders  concerning  the  ac- 
ceptance of  the  bond  offered,  was  whether  the  new  four  per 
cent  bond  would  sell  at  par.  At  the  time,  there  was  every 
indication  that  the  new  bonds  would  sell  at  a  high  price. 
For  the  nine  months  ending  March  31,  1901,  the  St.  Louis 
&  San  Francisco  had  shown  surplus  earnings  over  fixed 
charges  of  $1,451,817,  and  it  was  estimated  that,  for  the 
year,  these  surplus  earnings  would  be  $1,725,000.  The  direct 
saving  in  interest  by  the  refunding,  in  case  all  the  bonds  were 
got  in,  was  $70,000,  In  addition,  it  was  expected  that  earn- 
ings would  be  largely  increased  as  a  result  of  capital  ex- 
penditures then  in  progress.  The  sequel  proved,  however, 
that  of  the  holders  of  the  underlying  bonds,  those  who  ac- 
cepted the  cash  offer  chose  the  better  part.  The  general 
four  per  cent  bonds  have  sold  below  par  ever  since  that  date. 
The  offer  by  the  syndicate  of  these  favorable  terms  was 
intended  to  reduce  the  amount  of  cash  required.  If  all 
the  bonds  could  be  called  in  and  exchanged,  the  syndicate 
could  pay  for  the  $30,000,000  of  refunding  bonds  with  the 
old  bonds,  advancing  only  a  small  amount  of  money,  and 
retaining  the  surplus  amount  of  bonds  for  sale. 

When  bonds  are  called  at  maturity,  they  may  be  taken 
up  with  stock  or  with  new  bonds  or  with  notes,  or  the  old 
bonds  may  be  extended.  The  methods  of  accomplishing  these 
various  forms  of  refunding  have  already  been  considered  in 
connection  with  the  handling  of  maturing  note  issues  and 
require  no  extended  discussion  here.  The  usual  method  is  to 
employ  the  bonds  of  an  issue  previously  authorized  for  the 


EEADJUSTMENT   OF   CAPITAL  ACCOUNT    403 

purpose  of  refunding.  Careful  provision  is  made  in  the 
mortgage  for  satisfying  the  claims  of  all  maturing  bonds, 
and  for  releasing  the  property  from  the  underlying  mortgages 
in  order  that  it  may  come  directly  under  the  security  of  the 
general  mortgage.  When  the  bond  market  is  unfavorable, 
notes  may  be  employed  to  fund  maturing  bonds,  or  the  bonds 
may  be  extended.  In  the  latter  case,  extra  inducements  must 
be  offered  to  the  holders  of  maturing  bonds  to  induce  them 
to  defer  their  claims. 


CHAPTER   XXXII 

RECEIVERSHIPS 

In  our  study  of  the  corporate  mortgage  we  have  seen  how 
large  and  sweeping  are  the  powers  of  the  trustee  in  refer- 
ence to  the  disposition  of  the  corporate  property  in  the 
event  of  bankruptcy.  The  trustee  has  the  authority  to  enter 
upon  the  property  of  the  corporation  and  to  operate  it,  col- 
lecting the  receipts.  Out  of  the  receipts  he  is  to  pay  its 
debts.  He  may  also  proceed  against  the  company,  and  se- 
cure a  sale  of  the  property  under  the  mortgage,  applying  the 
proceeds  to  the  liquidation  of  its  indebtedness.  The  theory 
of  the  mortgage,  therefore,  is  that  the  property  of  a  cor- 
poration which  fails  to  pay  its  debts  is  to  be  seized  by  the 
trustee  and  sold,  the  proceeds  being  applied  in  satisfaction 
of  its  obligations.  The  powers  of  the  trustee  of  a  corporate 
mortgage  have  been  taken  over  from  the  language  of  real 
estate  mortgages.  It  is  the  custom,  in  case  of  default  of  in- 
terest or  principal  on  debts  secured  by  real  estate  mortgage, 
for  the  creditor  to  realize  on  the  property  of  the  bankrupt 
by  having  it  forthwith  sold  under  the  authority  of  the  court, 
compelling  the  owner  to  either  bid  enough  at  the  sale  to  pay 
off  the  indebtedness  or  to  forfeit  possession  of  it.  It  is  also 
customary  in  the  settlement  of  the  affairs  of  mercantile 
houses  which  become  insolvent  that  the  creditors  should 
seize  their  stocks  of  merchandise  and  forthwith  have  them 
sold  by  the  court  for  their  benefit.  While  similar  remedies 
are  apparently  preserved  to  the  creditor  of  a  corporation  in 
the  terms  of  the  mortgage  by  which  his  bonds  are  secured, 
404 


RECEIVERSHIPS  405 

the  theory  of  the  corporation  mortgage  cannot,  in  many 
cases,  be  carried  out. 

Most  business  corporations  are  organized  in  the  field  of 
manufacturing,  mining,  or  transportation.  They  conduct 
their  business  with  properties,  which,  unlike  real  estate  or 
merchandise,  are  highly  specialized  to  some  particular  use, 
and  can  be  used  for  no  other  purpose.  Take,  for  example, 
the  property  of  a  railroad.  It  consists  of  terminals,  on  which 
stand  certain  buildings  which  can  be  used  for  nothing  else 
than  the  purposes  of  the  railroad,  of  certain  real  estate  in 
the  form  of  strips  of  land  100  feet  wide  and  thousands  of 
miles  in  length,  between  which  runs  the  track,  consisting  of 
rails,  spikes,  fish  plates  and  ties,  and  laid  in  ballast.  Over 
this  track  runs  the  railroad  equipment  consisting  of  cars  and 
locomotives.  We  have  here  a  different  kind  of  property  from 
a  store  building  or  a  farm.  The  property  of  the  railroad  can 
be  used  for  no  other  purpose  than  the  transportation  of 
passengers  and  commodities.  If  sold,  it  must  be  sold  to  an- 
other railroad  company. 

Furthermore,  a  railroad  property  is  a  unit.  To  the  suc- 
cessful operation  of  a  railroad,  all  the  items  above  enumerated 
are  essential.  A  railroad  must  have  main  lines  and  it  must 
have  branch  lines.  In  many  cases  it  must  control  coal  min- 
ing companies  which  furnish  it  traffic.  It  must  own  large 
amounts  of  real  estate  at  its  terminal  points,  and  must  have 
the  necessary  number  of  cars  and  locomotives,  a  stock  of  ma- 
terials and  a  cash  balance.  All  of  this  property  is  neces- 
sary to  the  operation  of  the  road.  No  part  of  it  can  be  sep- 
arated from  the  others  and  sold  without  destroying  a  large 
part  of  its  value.  Furthermore,  a  railroad  company  may 
have  valuable  charter  and  franchise  privileges,  without  which 
its  operations  could  not  be  conducted.  It  has  built  up  over 
a  number  of  years  a  wide-spreading  business  organization 
by  means  of  which  it  obtains  traffic.  The  value  of  this  prop- 
erty depends  on  the  income  which  can  be  obtained  from  its 
use.  If  we  look  on  the  value  of  the  company's  property  as 
the  capitalization  of  the  net  earnings  accruing  from  the 
27 


406  COEPOEATION   FINANCE 

operation  of  that  property,  we  must  admit  that,  to  the  earn- 
ing of  these  profits,  not  merely  a  physical  property  but  fran- 
chises and  business  organization  are  indispensable. 

It  follows,  therefore,  that  if  the  creditors  of  the  company 
should  enforce  the  liens  of  their  mortgages,  and  should  take 
the  property  away  from  the  company,  especially  in  those 
cases  where  the  different  mortgages  cover  different  portions 
of  the  property,  in  which  event  the  enforcement  of  their 
liens  will  break  the  property  to  pieces,  a  large  part  of  the 
value  of  this  property  will  be  immediately  destroyed.  In 
this  value  of  the '  property,  based  upon  its  earning  power, 
consists  the  security  of  creditors  and  the  equity  of  stock- 
holders. If,  however,  the  creditors'  claims  are  allowed  to 
take  their  natural  course  of  suit,  judgment,  attachment,  and 
execution,  the  property  of  the  company  will  be  broken  up, 
its  working  capital  seized,  the  equipment  hauled  off  its  lines, 
its  terminals  taken  from  it,  its  organization  destroyed,  the 
franchises  are  perhaps  lost  and  its  earning  power  reduced  to 
nothing.  The  effect  is  generally  to  make  it  impossible  for 
the  stockholders  to  recover  any  value  from  the  wreckage,  and 
to  seriously  jeopardize  the  security  of  even  underlying  mort- 
gage bonds  supposed  to  be  fully  protected  by  surplus  earn- 
ings. 

When  a  corporation  approaches  bankruptcy,  it  usually 
occurs  that  different  portions  of  its  property  have  been 
pledged  as  security  for  various  issues  of  bonds.  If  the  com- 
pany is  operating  a  railroad,  for  example,  there  are  several 
first  mortgages  covering  the  different  divisions  of  the  main 
line  of  the  railroad.  Then  over  these  is  probably  spread  the 
lien  of  a  general  or  blanket  mortgage.  Tributary  to  the 
main  line  of  the  railroad  are  a  number  of  branch  lines,  and 
each  one  of  these  may  carry  mortgages  to  secure  issues  of 
bonds.  These  bonds  have  probably  been  delivered  to  the 
parent  company  in  repayment  of  advances  to  the  subsidiary 
company.  The  parent  company  may  have  pledged  the  bonds 
as  security  for  an  issue  of  collateral  trust  bonds.  The  equip- 
ment of  the  company  may  be  covered  by  the  lien  of  a  car 


RECEIVEKSHIPS  407 

trust  lease.  The  company  perhaps  operates  coal-mining  com- 
panies which  have  bonds  outstanding  against  them.  The 
terminal  properties  may  also  be  pledged  as  security  for  sep- 
arate mortgages.  In  addition  to  all  these  complexities  of 
obligations,  there  may  be  unsecured  debentures  outstanding, 
issues  of  short-time  notes  and  bank  loans,  money  due  em- 
ployes and  to  concerns  which  have  furnished  supplies  and 
materials  to  the  railroad.  Suppose,  now,  each  one  of  these 
creditors  should  undertake  to  enforce  his  claim  against  the 
company,  which  he  has  the  undoubted  right  to  do.  Is  it  not 
evident  that  the  property  would  be  completely  disintegrated 
in  the  contest  of  creditors?  Each  set  of  creditors  would 
make  off  with  a  piece  of  the  corpus,  and  the  value  of  the 
property,  after  it  had  been  torn  to  pieces  %  the  creditors, 
would  have  little  relation  to  its  value  as  a  going  concern. 
The  organization  of  the  business  would  be  broken  up,  its 
markets  destroyed,  its  good  will  extinguished. 

It  is  manifestly  the  concern  of  all  parties  that  the  credi- 
tors should  be  prevented  from  exercising  their  rights  under 
their  various  mortgages  and  liens,  and  that  the  property  of 
the  company  should  be  placed  beyond  their  reach  so  that  the 
continuity  of  its  operations  may  be  undisturbed,  and  its 
earnings  may  continue  to  accrue  until  such  settlement  of 
its  aifairs  can  be  made  as  will  preserve  the  value  of  the 
property.  The  unsecured  creditors,  if  they  obtain  judgment 
and  levy  execution,  can  usually  find  some  property  to  at- 
tach, some  cash  or  materials  which  have  not  been  pledged 
as  security  for  any  loan,  but  if  they  laid  their  hands  upon 
the  working  capital  of  the  company,  they  may  compel  it  to 
cease  operations,  thereby  reducing  their  chances  of  recov- 
ering anything  more  than  what  they  have  seized  to  zero.  As 
for  the  secured  creditors,  if  they  sit  passive  and  allow 
the  merchandise  and  bank  creditors  to  prey  upon  the  com- 
pany, they  may  find  their  own  security  rapidly  disappear- 
ing. But  if  they  enforce  their  rights,  then  neither  stock- 
holders nor  unsecured  creditors  are  likely  to  receive  any- 
thing. 


408  COKPORATION   FINANCE 

A  typical  situation  resulting  in  an  application  for  a  re- 
ceivership is  described  in  a  letter  of  President  Bush,  of  the 
Western  Maryland  Railroad  Company  to  the  directors  of 
that  company  in  March,  1908,  in  which  he  sets  forth  the 
reasons  leading  to  the  receivership: 

"  The  gross  revenues  of  the  railway  for  the  six  months 
ended  December  31,  1907,  increased  $540,725,  or  20.332  per 
cent,  and  the  net  revenues  increased  $350,176,  or  30,224  per 
cent  over  those  of  the  corresponding  period  of  the  last  fiscal 
year,  with  a  resulting  surplus  over  all  fixed  charges,  includ- 
ing the  abnormally  high  cost  of  temporary  loans  and  re- 
newals. 

"  The  company  is  not  confronted  with  any  failure  of  its 
revenues  to  cover  its  full  fixed  charges,  and  its  business  has 
maintained  a  steady  growth  with  unmistakable  assurance  of 
continued  development.  It  has,  however,  maturing  obliga- 
tions, arising  out  of  its  temporary  provisions  for  capital  ex- 
penditures, and  it  must  at  an  early  date  encounter  the 
problem  presented  by  the  commodity  clause  of  the  Federal 
rate  law. 

"  As  you  are  aware,  this  company  has  outstanding  loans 
maturing  April  1,  1908,  to  the  amount  of  $3,776,750,  se- 
cured by  pledge  of  $5,037,000  of  its  first  mortgage  bonds. 
The  market  price  of  these  bonds — originally  in  considerable 
excess  over  the  loans,  has,  notwithstanding  substantial  in- 
crease in  gross  and  net  revenues,  shrunk  to  a  level  below  the 
face  of  the  loans. 

"  It  has  now  become  apparent  that  the  company  will  be 
unable  to  meet  these  loans  or  to  provide  additional  collateral 
to  secure  their  extension.  In  this  situation,  the  company 
Itself  will,  of  course,  be  unable  to  borrow  the  money  neces- 
sary to  meet  mortgage  interest  falling  due  on  the  first  of 
April  next." 

It  may  be  possible,  in  rare  instances,  to  secure  the  coop- 
eration of  all  creditors  in  deferring  the  enforcement  of  their 


KECEIVERSHIPS  409 

claims,  and  to  give  the  company  an  opportunity  to  recover 
itself  without  the  expense  of  a  receivership.  When  there 
are  only  bondholders  to  consider,  in  case  the  holders  of  the 
number  of  bonds  without  which  the  trustee  cannot  be  forced 
to  act,  can  cooperate  with  the  trustee  in  protecting  the  com- 
pany, the  necessary  relief  can  be  afforded  without  a  receiver- 
ship. Sometimes  bondholders'  committees  will  advance 
funds  to  meet  pressing  claims.  As  a  general  rule,  however, 
creditors  cannot  be  brought  together,  and  the  property  must 
be  protected  against  their  assaults. 

The  property  can  be  placed  beyond  the  reach  of  the  cred- 
itors by  invoking  the  aid  of  a  court  of  equity,  the  direct  rep- 
resentative of  the  sovereign  power  of  the  state  which  cre- 
ated the  corporation,  one  of  whose  recognized  duties  is  to 
take  charge  of  the  estates  of  bankrupt  individuals,  firms,  or 
corporations,  and  to  preserve  this  property  until  the  creditors 
can  make  a  settlement  with  the  bankrupt,  or  until  a  sale  can 
be  made  of  the  property  on  more  favorable  terms  than  can 
be  obtained  by  the  creditors  acting  each  for  himself.  The 
court  takes  charge  of  the  estate  of  a  bankrupt  corporation 
through  its  agent,  who  is  known  as  a  receiver.  The  receiver 
is  an  officer  of  the  court  to  whose  charge  is  intrusted  the 
estate  of  the  bankrupt  corporation.  The  judge,  in  placing 
the  property  of  the  company  in  the  hands  of  a  receiver,  takes 
it  away  from  the  corporation,  puts  it  out  of  reach  of  the 
creditors,  and  places  it  in  a  position  to  be  secured,  both  from 
the  mismanagement  of  officers  and  directors  and  the  attacks 
of  its  creditors. 

The  reason  for  the  appointment  of  a  receiver  has  al- 
ready been  indicated,  namely,  to  conserve  the  value  of  the 
company's  property.  He  is  often  appointed  at  the  instance 
of  the  directors  who  see  long  before  any  creditor  the  impend- 
ing insolvency  of  the  company,  and  who,  at  the  first  threat 
of  disaster,  fiy  to  the  shelter  of  a  court  of  equity.  The  situ- 
ation is  something  as  follows :  A  federal  judge  is  approached 
by  directors  of  some  corporation  which  is  in  difficulty,  either 
in  his  court  room  or  privately.     Accompanying  the  directors 


410  COEPOKATION   FINANCE 

is  a  creditor  of  the  company.  The  attorney  of  the  company 
informs  the  judge,  to  whom  in  most  cases  he  is  well  and  fa- 
vorably known,  that  his  client,  the  A.  B.  Corporation,  is  in- 
solvent and  he  produces  a  creditor  as  evidence  of  the  fact. 
The  creditor  states  that  the  company  owes  him  certain  money, 
and  the  officials  of  the  company  are  there  present  to  confirm 
that  the  debt  is  due,  and  that  the  company  is  unable  to  pay 
it.  In  the  interest  of  all  parties  concerned,  therefore,  the 
court  is  asked  to  appoint  a  receiver  to  take  charge  of  the 
property  until  a  settlement  of  its  affairs  can  be  obtained. 
The  plea  is  forcibly  made  that  unless  the  court  intervenes, 
by  appointing  a  receiver,  the  creditors  of  the  company  will 
seize  upon  its  property  and  will  render  it  unable  to  perform 
its  functions.  It  may  be  represented  that  the  embarrass- 
ment of  the  company  is  due  to  special  and  exceptional  causes, 
and  that,  if  the  court  takes  its  property  under  its  protection, 
a  few  months  will  suffice  to  extricate  the  company  from  its 
difficulties.  This  procedure  is  known  as  making  out  a  prima 
facie  case  for  the  appointment  of  a  receiver. 

If  the  judge  suspects  no  fraud  in  the  matter,  he  forthwith 
appoints  a  receiver,  first  temporarily,  until  the  other  parties 
in  interest  can  have  an  opportunity  to  be  heard,  and  after- 
wards, unless  good  reason  appears  for  discharging  the  re- 
ceiver, the  receivership  is  made  permanent.  While  most  bank- 
rupt companies  do  not  present  such  a  complex  situation  as 
we  have  supposed,  there  are  usually  at  least  three  conflicting 
interests  to  be  considered :  secured  creditors,  unsecured  credi- 
tors, and  stockholders.  The  stockholders,  it  is  true,  have  no 
claim  against  the  company  for  money  loaned,  but  they  have 
an  interest  in  the  company  which  will  be  sacrificed  if  its  prop- 
erty is  torn  from  it.  It  may  happen,  for  example,  that  the 
embarrassment  has  been  caused  by  the  maturing  of  a  note 
issue  which,  owing  to  the  condition  of  the  bond  market,  can- 
not be  funded  at  that  time.  Otherwise,  the  company  may  be 
abundantly  able  to  meet  its  obligations.  The  stockholders 
have  here  an  interest  which  deserves  recognition  and  pro- 
tection. 


RECEIVERSHIPS  411 

The  receiver  whom  the  judge  appoints  is  usually  an  offi- 
cial of  the  bankrupt  corporation,  often  its  chief  counsel. 
The  reason  for  making  such  an  appointment  is  that  the 
judge,  not  being  familiar  with  the  operation  of  a  railroad  or 
manufacturing  concern,  wishes  to  install  one  conversant  with 
the  business  and  who  can  carry  it  on  successfully.  If  he 
appointed  a  stranger  to  the  property,  it  might  suffer  injury. 
When  a  receiver  is  shown  unfit  to  hold  this  position,  or  if  it 
can  be  made  to  appear  to  the  court  tliat  with  a  particular 
receiver  in  control  of  the  property,  bankers  will  not  come  to 
its  assistance,  the  receiver  may  be  removed.  When  large  pub- 
lic companies  apply  for  the  appointment  of  a  receiver,  the 
court  is  usually  careful  that  the  appointment  is  acceptable 
to  all  interests  concerned.  President  Bush,  of  the  Western 
Maryland  Railroad  Company,  for  example,  was  appointed  re- 
ceiver of  the  property  of  that  company.  On  the  other  hand, 
in  1893,  President  McLeod,  of  the  Philadelphia  &  Reading 
Railroad  Company,  who  was  at  first  appointed  receiver,  was 
later  forced  to  resign,  owing  to  the  opposition  of  banking  in- 
terests who  held  him  responsible  for  the  failure  of  the  com- 
pany. 

Immediately  following  his  appointment,  the  receiver  as- 
sumes possession  of  the  property  of  the  company  under  the 
authority  of  an  order  of  the  appointing  court,  which  usually 
authorizes  the  receiver: 

(1)  To  take  possession  of  the  property  of  the  corpora- 
tion; to  keep  this  property  in  good  condition  and  repair,  and 
to  operate  the  property  just  as  the  corporation  operated  it; 

(2)  to  receive  the  income  from  the  property  and  to  ap- 
ply this  income  under  the  direction  of  the  court  to"  the  pay- 
ment of  operating  expenses  and  fixed  charges; 

(3)  to  collect  all  debts  due  the  company,  and  to  defend 
all  suits  to  which  it  may  be  defendant. 

In  the  performance  of  these  functions,  the  receiver  may 
employ  such  counsel  or  agents  as  he  may  deem  necessary. 


412  COKPOKATION   FINANCE 

He  must  ascertain  as  accurately  as  possible  the  status  of 
the  corporation,  and  make  a  report  to  the  court.  He  must 
also  make  further  reports  from  time  to  time,  and  must  ob- 
tain express  authority  for  any  extraordinary  action,  such  as 
the  discontinuance  of  interest  on  bonds  or  the  sale  of  cer- 
tain property. 

In  carrying  out  his  duties,  it  is  necessary  for  the  re- 
ceiver to  provide  money.  When  he  takes  charge,  he  usually 
finds  a  large  amount  of  wages  and  audited  vouchers  due  and 
unpaid.  The  property  of  the  company  has  usually  been 
allowed  to  deteriorate,  no  money  being  spent  out  while  the 
directors  were  endeavoring  to  tide  over  their  period  of  trial. 
He  also  finds  various  issues  of  bonds  whose  holders  set  up  a 
claim  to  the  earnings  accruing  from  the  operation  of  the 
business.  There  are  also  claimants  under  the  lease  of  prop- 
erty which  it  is  necessary  for  the  company  to  retain.  This 
situation  requires  that  the  receiver  should  provide  a  large 
amount  of  money  at  once  to  liquidate  the  more  pressing  claims 
against  the  company.  He  must  then  take  up  the  question  of 
dealing  with  the  various  creditors  who  may  in  the  meantime 
have  brought  suit,  usually  in  the  court  which  has  taken  charge 
of  the  property,  to  establish  their  various  claims.  In  carrying 
out  these  duties,  the  receiver  must  raise  a  considerable  amount 
of  money.  He  has  three  sources  to  rely  upon.  "Tirst,  such 
part  of  the  income  of  the  company  as  is  not  required  to  pay 
operating  expenses,  interest,  and  rentals ;  'Second,  the  interest 
and  rentals  themselves  ;'and^hird,  the  use  of  a  form  of  obliga- 
tion known  as  the  receiver's  certificate. 

The  receivership  may  have  been  caused  by  the  inability  of 
the  company  to  fund  or  extend  an  issue  of  short-time  notes. 
Aside  from  this,  the  company  may  be  solvent,  able  to  pay  all 
interest  claims.  If  the  property  is  earning  more  than  enough 
to  pay  the  fixed  charges  of  the  company  from  which  it  has 
been  taken  by  the  court,  and  in  case  the  receiver  elects  to 
pay  those  fixed  charges,  he  can  use  the  surplus  income  in  his 
hands  to  defray  any  proper  expenses  of  the  company.  In 
but  few  cases,  however,  is  this  surplus  income  sufficient  for 


KECEIVERSHIPS  413 

the  receiver's  needs.  He  must  obtain  additional  funds. 
These  he  gets,  in  the  first  instance,  by  reducing  the  fixed 
charges  of  the  company,  by  simply  declining  to  pay  certain 
amounts  of  interest  and  rentals.  The  creditors  are  power- 
less. The  property  which  secures  their  obligations  is  in  the 
receiver's  hands,  they  can  obtain  their  interest  only  by  an 
order  of  the  court.  If,  in  the  opinion  of  the  receiver,  whom 
the  judge  usually  supports,  the  needs  of  the  property  re- 
quire such  action,  he  need  pay  no  interest,  and  may  apply 
all  of  the  money  which  would  otherwise  go  to  the  creditors, 
to  pay  the  pressing  obligations  of  the  company.  As  a  rule, 
however,  whan  interest  has  been  earned,  it  is  paid  by  the 
receiver. 

The  owners  of  leased  property  need  not  submit,  unless 
they  desire,  to  the  forfeiture  of^the  rentals.  The  receiver 
has  no  title  to  their  property;  his  possession  of  it  depends 
upon  his  carrying  out  the  covenants  of  the  lease  under  which 
the  corporation  secured  it.  The  lessor  company,  in  case  he 
fails  to  pay  their  rental,  may,  at  any  time,  resume  possession 
of  the  leased  property,  and  may  sue  as  general  creditors  for 
any  unpaid  balance  on  the  rental  or  for  any  other  damage 
which  they  may  have  sustained.  When  leases  are  profitable 
to  the  lessee,  there  is  no  danger  that  the  receiver  will  run  an}'^ 
risk  of  losing  control  of  the  property.  With  unprofitable 
leases,  however,  this  method  of  refusing  to  pay  rentals  which 
have  not  been  earned  has  been  largely  employed.  Stock- 
holders in  the  lessor  company,  in  such  a  case,  are  deterred 
from  acting  in  defense  of  their  rights  by  the  practical  impos- 
sibility of  making  an  advantageous  arrangement  for  the  dis- 
position of  their  property  elsewhere.  In  few  instances,  how- 
ever, does  the  receiver  carry  his  powers  to  this  extreme.  He 
is  usually  satisfied  to  pay  interest  and  rentals  where  interest 
and  rentals  have  been  earned,  and  to  refuse  to  pay  only  in 
those  cases  where  the  property  has  not  produced  a  sufficient 
revenue  to  meet  the  specific  charges  upon  it. 

The  disbursement  of  the  revenues  coming  into  the  re- 
ceiver's hands  is  made  under  the  supervision  of  the  court 


414  COKPOKATION  FINANCE 

appointing  him.  An  illustration  of  the  method  usually  fol- 
lowed is  furnished  by  the  following  quotation  from  an  order 
issued  by  Judge  Lacombe,  making  permanent  the  receiver- 
ship of  the  New  York  City  Eailway : 

"In  the  matter  of  improvements  the  receivers  are  for- 
tunately relieved,  at  least  in  part,  from  the  burden  of  de- 
vising improvements  in  the  system  by  the  existence  of  the 
Public  Service  Commission. 

"  The  receipts  from  car  service  will  be  devoted  first  to 
maintenance,  including  all  necessary  repairs  and  replace- 
ments. Next  in  order  are  certain  fixed  charges  in  the  na- 
ture of  rentals  and  interest  falling  due  on  various  mortgage 
bonds  of  such  roads,  which  by  the  terms  of  the  leases,  the 
New  York  City  Eailway  Company  has  covenanted  to  pay. 
It  would  seem  to  be  to  the  public  interest,  because  of  facility 
of  transfer,  that  the  roads  which  were  being  run  by  the  City 
Eailway  when  receivers  were  appointed,  should  be  operated 
as  a  unit.  For  the  present,  therefore,  the  receivers  will  con- 
tinue to  pay  such  rentals  and  mortgage  interest. 

"This  will  not  include  the  rental  in  the  Third  Avenue 
Eailroad  which  will  fall  due  the  last  of  this  month.  A 
clause  in  the  lease  of  that  road  provides  that  default  in  the 
payment  of  any  installment  of  that  rental  cannot  be  availed 
of  for  six  months.  Long  before  that  time  sufficient  informa- 
tion can  be  gathered  (and  made  public)  by  the  receivers  to 
give  such  enlightenment  as  to  the  whole  situation  as  will  en- 
able the  court  to  deal  understandingly  will  all  questions  as 
to  payment  of  all  these  items  of  rent  and  mortgage  interest. 
"Before  default  is  made  in  any  case  (except  the  one 
above  referred  to  and  the  rental  due  October  15  to  the  Met- 
ropolitan Street  Eailway)  petition  will  be  filed  setting  forth 
all  the  facts  bearing  on  the  question  and  asking  instructions, 
and  a  day  will  be  fixed  on  which  not  only  the  parties  to  the 
suit,  but  all  in  any  way  interested  (including  the  Public 
Service  Commission)  will  be  heard  as  to  the  most  equitable 
and  wisest  course  to  pursue. 

"  Until  further  order,  the  receivers  will  also,  if  the  other 


EECEIVEESHIPS  415 

parties  to  such  arrangements  consent,  carry  out  the  arrange- 
ments by  which  the  New  York  City  Kailway  Company  op- 
erates certain  railroads  not  under  lease,  such  as  the  Dry  Dock 
East  Broadway  &  Battery  Railroad  and  the  Union  Eailway." 

To  obtain  the  money  required,  the  receiver  usually  re- 
sorts to  the  use  of  receiver's  certificates.  A  receiver's  certifi- 
cate is,  in  effect,  a  short-term  note  secured  by  a  first  mort- 
gage upon  all  the  property  in  the  receiver's  hands.  It  is 
true  that  when  the  property  was  in  the  possession  of  the 
company  the  title  to  the  property  may  have  been  vested  in 
trust  for  the  payment  of  bonds  with  a  trustee.  By  the  ap- 
pointment of  a  receiver,  however,  the  court  takes  into  its 
own  possession  the  title  to  the  property,  and,  like  any  other 
owner,  can  pledge  any  of  its  possessions  as  security  for  a 
loan.  These  certificates  may  be  either  without  date,  or  they 
may  run  for  a  definite  period.  An  illustration  of  the  first 
kind  of  receiver's  certificate  is  the  following,  issued  in  1880 
by  the  receivers  of  the  Philadelphia  &  Eeading  Eailroad 
Company : 

Eeceivers'    Office,    Philadelphia    &    Eeading   Eailroad 

Company. 
Philadelphia,  May  24,  1880. 

This  is  to  certify  that  there  is  due  to or  order 

from  Edwin  M.  Lewis,  Franklin  B.  Gowen  and 
Stephen  A.  Caldwell,  receivers  of  the  Philadelphia 
&  Eeading  Eailroad  Company  (and  not  individually) 
one  thousand  dollars,  on  account  of  money  borrowed  by 
said  receivers,  under  order  of  court,  for  payment  of 
wages  and  interest  upon  certain  mortgage  indebted- 
ness of  said  company. 

This  certificate  is  transferable  by  indorsemerft,  and 
redeemable  after  ten  days'  notice  by  advertisement  in 
one  or  more  daily  papers  of  the  City  of  Philadelphia, 
of  the  readiness  of  the  receivers  to  make  payment 
at  the  expiration  of  which  notice  interest  thereon  shall 
cease.  Eeceivers, 

(Signed)     W.  McKenna, 

Circuit  Judge. 


416  COKPORATION   FINANCE 

The  later  form  of  certificate  is  illustrated  by  those  is- 
sued in  1910  by  the  receivers  of  the  Illinois  Tunnel  Com- 
pany : 

This  is  to  certify  that  for  value  received  Charles 
G.  Dawes  and  David  R.  Forgan,  as  receivers  of  the 
Illinois  Tunnel  Company,  and  not  individually,  are  in- 
debted to  the  bearer  hereof  in  the  sum  of  one  thous- 
and dollars  ($1,000),  payable  at  the  National  City 
Bank  of  New  York,  in  the  City  of  New  York,  or,  at 
the  option  of  the  holder  hereof,  at  the  Continental 
National  Bank,  in  the  City  of  Chicago,  two  years  from 
the  date  hereof,  in  gold  coin  of  the  United  States  of 
America  of  the  present  standard  of  weight  and  fine- 
ness, with  interest  thereon  at  the  rate  of  six  per 
cent  (6%)  per  annum,  payable  semiannually,  in 
like  gold  coin,  on  the  first  days  of  October  and  April, 
upon  presentation  and  surrender,  at  one  of  the  places 
therein  specified,  of  the  coupons  for  said  interest  as 
they  severally  mature. 

This  certificate  is  part  of  an  issue  of  certificates  of 
like  tenor  and  date  not  exceeding  in  the  aggregate  the 
principal  sum  of  three  million  five  hundred  thou- 
sand dollars  ($3,500,000)  at  any  one  time  outstanding, 
authorized  by  an  order  of  the  Circuit  Court  of  the 
United  States  for  the  Northern  District  of  Illinois, 
Eastern  Division,  dated  the  16th  day  of  March,  1910, 
and  on  said  day  filed  in  the  office  of  the  clerk  of  said 
court,  entitled  in  two  certain  actions  pending  in  said 
court  and  consolidated  under  the  title*  of  The  Cor- 
poration Trust  Company  against  Illinois  Tunnel  Com- 
pany and  Central  Trust  Company  of  Illinois,  as  Trus- 
tee, against  the  Illinois  Tunnel  Company,  and  others. 
This  certificate  is  issued  pursuant  to  and  is  entitled 
to  the  benefits  and  security  specified  in  the  foregoing 
order,  subject  to  all  the  terms  and  provisions  whereof 
this  certificate  is  issued  and  held.  Among  other 
things  it  is  provided  in  said  order  that: 

"  Said  certificates  of  indebtedness  to  the  amount  of 
the  principal  and  interest  thereof  shall  constitute  a 
lien  upon  all  the  property  of  every  nature  and  descrip- 
tion of  the  defendant  Illinois  Tunnel  Company,  and 
upon  the  telephone  system  which  may  be  constructed 


EECEIVEKSHIPS  417 

by  the  said  receivers,  and  upon  all  equipment  and 
other  property  that  may  be  acquired  or  provided  by 
means  of  the  said  certificates  or  the  proceeds  thereof, 
and  upon  all  net  earnings  and  income  which  may  here- 
after result  from  the  operation  of  the  property  in 
charge  of  the  said  receivers,  which  lien  shall  be  prior 
to  the  lien  of  the  judgment  received  in  this  court 
by  the  Corporation  Trust  Company  against  the  Illinois 
Tunnel  Company  on  December  1,  1909,  for  $1,129,- 
428.64  and  prior  to  the  lien  of  the  First  Mortgage  or 
Deed  of  Trust,  dated  December  1,  1903,  made  by  the 
Illinois  Tunnel  Company  to  the  Equitable  Trust  Com- 
pany, Chicago  as  Trustee  (under  which  indenture  the 
Central  Trust  Company  of  Illinois  is  now  the  duly 
constituted  and  acting  successor  Trustee),  and  prior 
to  the  rights  of  the  holders  of  any  and  all  bonds  is- 
sued under  the  said  First  Mortgage  or  Deed  of  Trust." 


These  obligations  are  managed  like  short-term  notes. 
They  may  be  issued  to  consolidate  other  issues  of  the  same 
kind;  they  may  be  called  at  any  time;  or  they  may  be  ex- 
tended at  maturity. 

Money  is  provided  by  receivers'  certificates  for  various 
purposes.  These  obligations  are  usually  issued  in  small 
amounts,  soon  after  the  receiver  takes  charge,  to  pay  pressing 
claims,  e.  g.,  for  wages  and  supplies.  Larger  issues  may  pro- 
vide for  repairs  which  are  necessary  to  the  operation  of  the 
property.  As  a  rule,  a  receiver  will  go  no  further  than  this 
in  asking  authority  to  issue  receivers'  certificates.  Bond- 
holders can  have  no  objection  to  the  provision  of  money  for 
the  purposes  indicated.  It  is  true  that  the  lien  of  the  cer- 
tificates precedes  that  of  the  first  mortgage,  but  if  the  re- 
ceiver did  not  provide  the  money,  the  property  could  not  be 
operated  economically  and  its  value  would  dwindle  to  the 
injury  of  its  creditors.  Receiver  Frederick  W.  Whitridge, 
who  took  possession  of  the  Third  Avenue  Railroad  on  Janu- 
ary 12,  1908,  on  May  9th,  reported  to  the  Chairman  of  the 
Bondholders'  Committee,  showing  the  situation  arising  out 
of  the  previous  neglect  of  the  property  with  which  the  re- 


418  CORPOKATION  FINANCE 

ceiver  must  promptly  deal,  if  he  is  to  maintain  and  increase 
its  earnings.  This  portion  of  his  report  is,  in  part,  as  fol- 
lows: 

"Physical  Condition. — The  general  conditions  of  the 
Third  Avenue  Railroad  were  very  bad;  there  were  no  offices, 
no  supplies,  or  material  on  hand;  the  shops  had  been  ne- 
glected; the  track  was  and  is  in  very  bad  shape;  the  cars  in 
need  of  extensive  repairs.  The  power  house  alone  was  in 
good  condition. 

"The  supplies  and  material  immediately  necessary,  most 
of  which  has  been  received,  amounted  to  $50,000.  Sprink- 
ling apparatus  in  all  of  the  barns  and  the  cost  of  the  various 
other  fire  apparatus  essential  to  secure  new  insurance,  the 
old  policies,  after  the  repeated  fires  in  the  New  York  City 
Railway  barns,  having  been  nearly  canceled,  amounted  to 
$135,000;  I  hope  presently  that  the  property  upon  the  sys- 
tem will  meet  the  requirements  of  the  most  exigent  under- 
writers. 

"  Car  Repairs. — Of  the  567  cars  delivered  to  me  by  the 
New  York  City  Railway  Company  receivers,  there  was  not 
one  on  which  some  work  was  not  immediately  necessary.  I 
ordered  a  sufficient  number  of  new  motors  and  controllers 
(50)  to  fully  equip  every  car  in  the  system.  I  estimate  the 
total  cost  of  putting  all  the  cars  in  order,  including  the  new 
motors  and  other  electrical  equipment,  to  be  approximately 
$300,000. 

"Repair  to  Track. — In  many  places  on  the  main  line  of 
the  Third  Avenue  track  the  contact  rail  is  completely  worn 
away,  the  slot  rail  very  thin,  and  the  car  rail  worn  to  the 
breaking  point.  Paving  of  the  tracks,  in  accordance  with 
the  city  ordinance,  with  Belgian  blocks,  will  save  $5,000  or 
$6,000  a  year  in  maintenance.  Under  a  temporary  arrange- 
ment with  the  New  York  City  Railway  receivers,  we  are  to 
repair  the  crossings  on  joint  account.  Altogether  there  will 
be  needed  for  the  track  this  year  about  $436,000  and  there- 
after, with   a  liberal   allowance   for  maintenance,   I   think 


RECEIVEESHIPS  419 

no  further  expenditure  will  be  necessary  for  some  years  to 
come. 

''Buildings. — The  building  at.  Sixty-fifth  Street  and 
Third  Avenue  needs  extensive  repairs  to  the  roof,  and  in  or- 
der to  enable  the  shops  to  do  their  work  certain  other  struc- 
tural alterations  are  required,  bringing  up  the  total  cost  to 
about  $151,000  for  $14,821  of  which  amount  I  have  let  con- 
tracts. 

"  At  129th  Street  and  Third  Avenue  there  is,  in  front  of 
the  car  barn,  a  building  used  as  a  hotel  and  several  tumble- 
down stores  or  saloons.  I  propose  to  clean  out  the  main 
building  and  construct  therein  proper  offices  for  the  Third 
Avenue  and  other  lines;  also  accommodations  for  a  club  for 
the  employees,  which  are  much  needed.  The  whole  improve- 
ment will  cost  nearly  $106,000." 

To  meet  the  cost  of  these  and  other  improvements  and 
payments,  the  receiver  stated: 

"  I  intend  to  ask  the  court  for  authority  to  issue  $2,500,- 
000  of  receivers'  certificates,  payable  within  one  year  and 
bearing  interest  at  the  rate  of  six  per  cent.  With  those  and 
the  earnings  from  the  property  I  think  I  can  do  all  of  the 
work  and  make  all  the  payments  which  I  have  herein  enu- 
merated. It  may  be  desirable  to  issue  a  certain  number  of 
certificates  of  the  Union  Railway,  to  an  amount  necessary  to 
pay  for  the  car  barns,  the  Bronx  &  Pelham  Parkway  construc- 
tion, and  for  the  power  station,  not  exceeding  in  all,  however, 
$750,000,  which  could  later  be  taken  up  by  the  Third  Avenue 
certificates ;  or  it  may  be  desirable,  while  having  authority,  to 
issue  certificates  for  the  Union  Railway,  as  above  mentioned, 
as  I  already  have  authority  to  issue  certificates  for  the  Forty- 
second  Street  and  the  Dry  Dock  railways  of  which  I  have  not 
availed  myself,  to  issue  Third  Avenue  certificates  for  the  whole 
amount  of  $2,500,000  directly,  as  the  bankers  may  prefer  those 
to  certificates  of  the  other  roads.  If  the  certificates  of  those 
subordinate  lines  could  be  used  permanently,  the  Third  Ave- 
nue certificates  should  be  diminished  pro  tanto,  but  in  any  case 


420  CORPORATION  FINANCE 

only  certificates  for  $2,500,000  for  one  year  will  be   out- 
standing." 

Cases  may  arise,  however,  when  receivers  must  go  much 
further  in  the  issue  of  these  obligations  than  the  payment  of 
accrued  wages  and  the  making  of  necessary  repairs.  The 
property  of  the  company,  as  with  the  Illinois  Tunnel  Com- 
pany, may  be  only  in  part  completed.  Unless  it  is  finished 
at  once,  it  may  not  be  possible  to  secure  profitable  business. 
For  example,  in  anticipation  of  the  construction  of  a  power 
plant,  contracts  with  consumers  may  have  been  signed  whose 
binding  force  depends  upon  the  delivery  of  power  before  a 
certain  date.  The  company  may  have  failed,  leaving  the 
plant  half  finished,  and  a  receiver  takes  charge  of  the  prop- 
erty. He  finds  a  rival  concern  ready  to  run  lines  into  this 
section  and  seize  the  market  for  power.  The  receiver,  under 
these  conditions,  may  have  no  choice  but  to  mortgage  the 
property  to  obtain  funds  for  its  completion  in  order  to  de- 
liver power  and  secure  the  benefit  of  the  contracts.  He  takes 
this  action  as  much  in  the  interest  of  the  creditors  as  of  the 
stockholders.  Unless  receivers'  certificates  were  issued,  the 
power  plant  when  finished  would  find  its  market  absorbed 
by  its  rivals. 

Existing  creditors  of  the  company  are  violently  opposed  to 
the  issue  of  receivers'  certificates  of  large  amount  and  often 
appeal  to  the  court  not  to  allow  the  receiver  to  place  this 
new  encumbrance  ahead  of  the  lien  on  their  security.  Their 
pleas  are,  however,  usually  disregarded.  The  court  stands 
by  its  own  appointee,  the  receiver,  and  is  usually  guided,  as 
to  the  necessity  of  the  issue  of  certificates,  by  the  receiver's 
recommendations.  The  amount  of  money  which  the  •  re- 
ceiver will  spend  upon  the  property  depends  on  his  concep- 
tion of  his  duties.  If  he  looks  upon  his  obligation  as  merely 
to  preserve  the  business,  as  it  were,  in  a  state  of  suspended  ani- 
mation, doing  as  little  as  possible  to  repair  or  improve  the 
property,  merely  protecting  it  from  the  onslaught  of  creditors 
until  the  different  interests  can  be  adjusted  and  the  receiver 


EEGEIVEESHIPS  421 

discharged,  he  is  not  apt  to  issue  more  certificates  than  are  nec- 
essary to  pay  the  claims  which  press  upon  him  in  the  form 
of  unpaid  wages,  etc.,  when  he  takes  charge  of  the  property. 
If,  however,  he  interprets  the  word  conservation  in  its  broad 
sense,  he  may  conceive  it  to  be  his  duty  not  only  to  preserve 
the  property,  but  also  to  do  all  things  necessary  to  increase 
its  efficiency.  In  carrying  out  this  obligation  he  may  bor- 
row large  sums  of  money,  and  he  may  do  a  considerable 
amount  of  important  work  and  even  new  construction.  An 
illustration  of  this  conception  of  the  receiver's  duties  is  fur- 
nished by  the  receivership  of  the  Baltimore  &  Ohio  Eailroad 
Company. 

The  receivers  appointed  for  the  Baltimore  &  Ohio  in 
1896  were  Mr.  John  K.  Cowen  and  Mr.  Oscar  G.  Murray. 
They  were  confronted  with  a  difficult  situation.  The  prop- 
erty of  the  company  was  in  need  of  entire  reconstruction. 
Ties,  roadbed,  rails,  bridges,  piers,  cars,  and  locomotives 
were  sadly  in  need  of  replacement  or  repair.  The  equipment 
of  the  company  was  particularly  defective,  a  large  number 
of  freight  cars  and  locomotives  being  out  of  service,  and  the 
equipment  available  for  use  being  entirely  insufficient  to  take 
care  of  the  traffic  offering.  Moreover,  the  competitive  situa- 
tion of  the  Baltimore  &  Ohio  was  at  this  time  peculiarly 
unfortunate.  To  the  north  lay  the  Pennsylvania,  equipped 
to  handle  traffic  at  the  lowest  cost.  On  the  south  the  Chesa- 
peake &  Ohio  was  a  vigorous  competitor,  both  for  through 
traffic  from  the  West  and  for  the  rapidly  growing  coal  traf- 
fic out  of  West  Virginia.  Unless  the  Baltimore  &  Ohio  was 
to  abandon  the  field  to  its  competitors,  it  must  be  placed  in 
a  position  to  carry  traffic  at  the  lowest  possible  cost.  In  other 
words,  the  Baltimore  &  Ohio  must  be  entirely  reconstructed. 

Should  the  receivers  reconstruct  the  road,  obtaining 
funds  by  the  issue  of  their  certificates,  or  should  they  con- 
tent themselves  with  keeping  the  system  together  and  in  pas- 
sable running  order,  leaving  the  work  of  rebuilding  to  the 
officers  of  the  company  after  it  had  been  provided  with  funds 
in  a  reorganization?     The  receivers  wisely  chose  the  first 


422  COKPORATION  FINANCE 

alternative,  notwithstanding  powerful  opposition  and  a  vig- 
orous controversy  between  their  friends  and  men  who  as- 
serted that  they  were  exceeding  their  authority  as  receivers. 
New  capital  had  to  be  issued  eventually.  To  delay  the  work 
of  improvement  meant  at  least  temporary,  abandonment  of 
the  competitive  field,  and  the  loss  of  advantages  which 
might  never  be  regained.  Mr.  Cowen  and  Mr.  Murray  faced 
the  issue  squarely.  As  receivers  of  the  Baltimore  &  Ohio 
they  issued  within  two  years  $10,742,000  of  receivers'  cer- 
tificates, in  addition  to  a  large  amount  of  car-trust  obliga- 
tions. A  portion  of  these  certificates  were  exchanged  for 
other  evidences  of  indebtedness  which  had  to  be  taken  care 
of,  but  for  the  most  part  they  were  issued  for  new  equipment, 
rails,  and  ties. 

Immediately  after  taking  charge  of  the  property,  in  May, 
1896,  the  receivers  obtained  authority  to  purchase  five  thou- 
sand new  freight  cars  and  seventy-five  locomotives.  In  Feb- 
ruary, 1897,  a«  thousand  additional  box  cars  were  purchased, 
and  in  May  of  the  same  year  five  thousand  one  hundred  and 
fifty  more  cars  were  acquired.  During  this  year  two  thou- 
sand one  hundred  and  fifty  cars  were  obtained  from  coal 
companies  on  mileage  contracts,  and  three  thousand  cars 
were  leased  from  the  Pullman  Company.  Besides  these 
heavy  purchases  of  equipment,  during  the  first  year  of  the 
receivers'  administration  two  hundred  and  twenty  freight 
engines,  some  of  which  had  not  turned  a  wheel  for  months, 
were  sent  through  the  shops  and  put  into  service.  Special 
attention  was  also  paid  to  the  way  and  structure.  The  track 
from  Baltimore  to  Pittsburg  and  Wheeling  was  practically 
all  relaid  with  new  and  heavier  rails  and  new  ties.  Bridges 
on  the  system,  many  of  which  were  unable  to  bear  the  weight 
of  heavy  trains,  were  generally  replaced;  and  large  sums 
were  spent  on  the  construction  of  yards  and  sidings.  Tak- 
ing advantage  of  depressed  times,  one  of  the  features  of  the 
receivership  was  the  placing  of  an  order  for  forty  thousand 
tons  of  eighty-five-pound  rail,  said  to  have  been  the  largest 
order  ever  placed  for  rails  up  to  that  time.     The  price  was 


RECEIVERSHIPS  423 

seventeen  dollars  a  ton.  Not  all  the  funds  for  these  im- 
provements were  raised  by  the  issue  of  receivers'  and  car- 
trust  certificates.  Earnings  were  heavily  drawn  upon,  and 
in  many  instances  bondholders  were  forced  to  wait  until  the 
property  on  which  they  had  a  lien  was  put  into  condition  to 
earn  the  interest.  In  a  word,  the  Baltimore  &  Ohio  re- 
ceivers rebuilt  the  road  from  end  to  end,  and  turned  a  new 
road  over  to  the  stockholders  when  the  reorganization  was 
completed. 

This  work,  as  intimated  above,  was  not  carried  through 
without  severe  opposition.  Suit  after  suit  was  brought  by 
security  holders  to  restrain  the  receivers  from  increasing  the 
burdens  of  the  property.  It  was  urged  that  they  were  de- 
stroying the  value  of  first  mortgage  bonds  by  their  reckless 
issue  of  certificates,  and  they  were  advised  that  if  new  equip- 
ment was  needed,  it  should  be  borrowed  and  not  purchased. 
Their  policy  was  denounced  as  a  gross  usurpation  of  power 
because,  as  it  was  charged,  they  ran  counter  to  every  prece- 
dent which  should  regulate  the  conduct  of  receivers.  To 
this  the  answer  was  made  that  precedents  were  indeed  vio- 
lated, but  that  the  situation  with  which  the  receivers  had  to 
deal  was  itself  unprecedented.  The  receivers  contended,  and 
in  this  they  were  sustained  by  the  court,  that  their  policy  was 
conceived  in  the  interest  of  the  bondholders,  and  they  insisted 
that  it  be  carried  through  to  completion. 

The  policy  of  the  receivers  of  the  Baltimore  &  Ohio  was 
abundantly  justified  during  their  term  of  office.  During  a 
period  when  the  gross  earnings  of  its  competitors  declined 
the  earnings  of  the  Baltimore  &  Ohio,  as  the  direct  result 
of  its  larger  equipment  and  lower  operating  cost,  materially 
increased.  In  1896,  gross  earnings  were  $25,582,000  and 
in  1898,  after  the  reconstruction  of  the  property  had  been 
practically  completed,  they  increased  more  than  $2,000,000 
in  spite  of  a  steady  fall  in  rates.  The  contribution  of  reduced 
operating  expenses  to  the  result  is  seen  in  the  increase  of  the 
operating  ratio  from  69.26  in  1895,  a  ratio  which  directly  re- 
flected the  inefficiency  of  the  property,  to  78.23  per  cent  in 


424  COKPOKATION  FINANCE 

1898,  which  represented  the  expenditure  of  a  large  amount 
of  earnings  upon  improvements.  The  effect  of  these  im- 
provements upon  the  operating  efficiency  of  the  road  is  seen 
in  a  decline  in  the  operating  ratio  from  76.70  per  cent  in 
1899  to  65.63  in  1900.  The  Baltimore  &  Ohio  receivers  took 
great  risks.  They  applied  a  desperate  remedy  to  a  desperate 
situation.  Their  success  on  this  account  was  all  the  more  con- 
spicuous and  brilliant. 

A  receivership  is  an  extraordinary  remedy  for  an  extraor- 
dinary  situation.  XJke  a  surgical  operation,  although  it  may 
save  the  life  of  a  distressed  corporation,  it  usually  leaves  the 
patient  in  a  weakened  condition  from  which  his  recovery  is 
slow.  And  for  the  same  reason  that  intelligent  physicians 
only  .resort  to  the  knife  after  all  milder  measures  of  treat- 
ment have  failed,  so  the  owners  ^nd  creditors  of  a  corpora- 
tion which  has  got  into  difficulties,  consult  their  best  interests, 
when  they  unite  to  tide  over  the  crisis  without  resorting  to 
the  protection  of  the  courts.  As  yet,  however,  such  a  de- 
gree of  cooperation  cannot  be  expected,  and  it  is  fortunate 
for  the  investor  that  the  courts  have  generally  shown  wis- 
dom and  foresight  in  the  administration  of  properties  in- 
trusted temporarily  to  their  keeping. 


CHAPTER    XXXIII 
THE    REORGANIZATION  OF  BANKRUPT  CORPORATIONS 

The  reorganization  of  a  bankrupt  corporation  is  a  set- 
tlement of  the  claims  of  the  different  parties  in  interest  on 
such  a  basis  that  the  property  can  be  released  by  the  court  and 
again  managed  as  a  going  concern. 

As  soon  as  possible  after  the  receivers  have  been  ap- 
pointed, efforts  are  set  in  motion  looking  to  the  rehabilita- 
tion of  the  bankrupt  corporation.  The  interests  of  all  con- 
cerned point  to  a  speedy  settlement  of  its  difficulties.  As 
long  as  a  corporation  remains  in  the  hands  of  the  receiver, 
the  values  of  its  securities  are  low,  owing  to  its  uncertain 
future.  Those  persons  whose  capital  is  invested  in  these 
bonds  and  stocks  are  unable  to  find  purchasers  for  their  in- 
vestments at  fair  prices,  or  to  make  loans  upon  these  secur- 
ities with  financial  institutions.  Banks  and  trust  companies 
which  have  taken  these  securities  as  collateral  are,  for  the 
same  reason,  unable  to  dispose  of  the  collateral  except  at  a 
loss,  even  if  they  consider  it  expedient  to  further  complicate 
an  already  difficult  situation  by  such  a  drastic  action.  All 
interests  are,  therefore,  equally  concerned  to  reach  a  speedy 
reorganization  of  a  bankrupt  company.  Unless  an  attempt 
is  made  to  treat  some  interest  unfairly,  the  operation  is 
quickly  concluded  and  a  settlement  is  reached  which  preserves 
the  integrity  of  the  business,  and  equitably  apportions  among 
the  different  claimants  the  losses  which  have  been  sustained. 
The  courts  have  also  assumed  the  necessity  of  speedy  reorgan- 
ization, and  have  sometimes  gone  so  far  as  to  recommend  to 
creditors  and  stockholders  that  they  hasten  to  arrive  at  a 

425 


426  COKPOKATION   FINANCE 

settlement  of  their  difficulties  in  order  that  the  receivers  may 
^be  discharged. 
;       The  objects  of  the  reorganization  are  as  follows : 

1.  To  pay  off  or  fund  the  floating  debt. 

2.  To  provide  funds  for  betterments  and  working  capital 
md  to  arrange  for  future  capital. 

3.  To  reduce  fixed  charges  within  a  conservative  estimate 
lof  net  earnings. 

I  Reorganization,  in  almost  all  cases,  requires  that  a  large 
amount  of  cash  should  be  provided.  This  money  is  required 
to  pay  certain  kinds  of  current  debt,  to  complete  an  un- 
finished plant,  or  for  the  reconstruction  and  repair  of  prop- 
erty whose  physical  condition  has  been  allowed  to  deteriorate. 
Taking  up  first  the  floating  debt  which  must  be  provided  for, 
we  find  this  usually  divided  into  receiver's  certificates  and 
secured  loans.  The  receiver's  certificates,  as  already  ex- 
plained, constitute  prior  liens  on  the  property,  and  must  be 
paid  in  cash  when  due.  We  have  also  seen  in  the  discussion 
of  the  issue  of  short  term  obligations  that  these  are  now 
almost  invariably  secured  by  a  large  margin  of  collateral. 
These  notes  have  been  usually  taken  by  banks,  trust  com- 
panies or  large  individual  capitalists.  The  collateral  back 
of  them  consists  either  of  bonds  authorized  under  existing 
mortgages,  or  of  securities  owned  by  the  corporation  repre- 
senting the  control  of  properties  which  are  indispensable  to 
it.  The  holders  of  such  notes  are  in  a  position  to  demand 
payment  in  full.  Unless  paid,  they  can  sell  their  collateral 
and  seriously  embarrass  those  who  are  endeavoring  to  re- 
organize the  company. 

The  physical  condition  of  a  bankrupt  property  is  usually 
bad.  In  some  cases  the  original  financial  plan  has  not  pro- 
vided sufficient  funds  to  complete  the  plant  which  must  be 
finished  before  it  is  of  any  value,  and  the  property  of  going 
concerns  has  often  suffered  severely  before  receivers  were 
appointed.  The  receiver,  as  we  have  seen,  may  do  much  to 
improve  the  physical  condition  of  the  property,  but  he  is  not 
likely  to  provide  all  the  money  necessary. 


REOKGANIZATION   OF   COEPORATIONS      427 

The  reorganization  plan  should  provide  that  the  net  earn- 
ings of  the  company,  on  a  minimum  estimate,  should  insure 
a  safe  margin  above  fixed  charges.  If  the  receivership  has 
been  due  to  the  maturity  of  debt  at  a  time  when  financing 
was  not  possible,  a  reduction  of  fixed  charges  may  not  be 
necessary.  In  the  great  majority  of  cases,  however,  adversity 
has  disclosed  the  fact  that  fixed  charges  are  too  heavy  for 
the  earnings  of  the  company,  and  opportunity  is  taken  in  the 
reorganization  to  reduce  them.  Unless  this  is  done,  at  the 
next  season  of  trial,  net  earnings  may  again  fall  below 
charges,  and  another  surgical  operation  on  the  capitalization 
of  the  company  will  become  necessary.  It  is  seldom  provided 
that  fixed  charges  in  the  reorganization  plan  should  be  so 
much  reduced  that  an  estimate  of  net  earnings  based  on 
present  conditions  will  insure  immediate  payment  of  divi- 
dends. Such  a  course  would  be  unfair  to  creditors.  If  re- 
viving business  increases  earnings  after  the  reorganization, 
to  the  point  of  dividend  payment,  that  is  the  good  fortune 
of  the  stockholders;  but  the  creditors  cannot  be  asked  to  sub- 
mit to  a  greater  reduction  in  their  claims  for  interest  and 
rentals  than  is  sufficient  to  enable  the  company  out  of  its 
net  earnings  to  pay  interest  and  provide  for  working  capital, 
renewals  and  betterments.  The  information  upon  which  any 
plan  of  reorganization  must  be  based  is  usually  supplied  by 
the  receivers  who  make  for  the  court  an  exhaustive  analysis 
of  the  situation  of  the  pmnpanyj  ifsj^^gf.  pflrniTior  power,  the 
causes  of  failure,  a  schedule  of  its  assets  and  liabilities^  and 
an  estimate  of  its  cash  requirements, 

We  see  the  objects  of  reorganization.  How  are  these 
objects  to  be  realized?  The  first  step  in  carrying  through 
a  reorganization  plan  is  usually  the  formation  of  committees 
to  represent  the  owners  of  different  classes  of  bonds.  In  some 
cases  also  committees  are  formed  to  represent  stockholders. 
The  purpose  of  forming  committees  is  to  secure  united  action 
on  behalf  of  each  interest  concerned  in  the  reorganization, 
and  also  to  keep  the  various  bonds  and  notes  of  the  company 
from  being  thrown  on  the  market  and  sacrificed.    The  forma- 


428  COKPOKATION  FINANCE 

tion  of  committees  may  not,  it  is  true,  be  necessary.  The 
receivers  or  the  directors  may  themselves  formulate  a  plan 
of  reorganization,  or  they  may  appoint  a  committee  to  for- 
mulate such  a  plan  to  which  they  may  afterwards  invite  the 
consent  of  the  security  holders.  If  the  plan  proves  satisfac- 
tory, it  may  at  once  be  put  into  effect.  It  is  seldom,  how- 
ever, that  such  a  quick  method  of  settlement  can  be  adopted. 
Holders  of  different  classes  of  securities  are  unlikely  to  con- 
sent to  any  plan  which  they  have  had  no  hand  in  formu- 
lating. 

The  method  usually  employed  in  the  formation  of  these 
committees  is  for  individual  bondholders  to  constitute  them- 
selves or  their  representatives  a  committee  to  take  charge  of 
the  particular  class  of  securities,  and  to  invite  the  creditors  or 
stockholders  to  signify  their  consent  to  this  arrangement  by 
depositing  their  securities  with  some  disinterested  agent,  a' 
trust  company  or  bank.  If  a  majority  of  the  securities  are 
thus  deposited,  the  self-constituted  committee  becomes  rep- 
resentative, and  is  recognized  as  such  by  the  courts.  The 
powers  of  these  committees  are  very  broad.  The  committee 
is  vested  with  the  legal  title  to  all  securities  deposited  with 
them,  and  is  authorized  to  act  in  all  respects  in  behalf  of 
the  depositors  as  though  they  were  directors  of  a  corporation 
elected  for  the  purpose.  The  committee  has  all  the  powers 
of  owners  of  the  securities,  and  full  discretion  as  to  the  meth- 
ods of  carrying  out  the  agreement.  The  committee  is  author- 
ized to  institute  suits  or  to  intervene  in  suits,  to  sell  the 
deposited  securities  under  certain  conditions,  to  employ 
agents,  attorneys  and  counsel,  to  purchase  property  at  fore- 
closure sale,  to  borrow  money  on  the  security  of  the  bonds 
or  stocks  deposited  with  them,  and  also,  usually,  to  prepare 
a  plan  of  reorganization  which,  after  reasonable  notice  has 
been  given  to  the  depositors  under  the  agreement  with  the 
committee,  and  failing  objection  on  their  part  signified  by 
the  withdrawal  of  their  securities,  is  held  to  be  binding  upon 
all.  The  depositors  are  held  to  be  liable  for  the  necessary 
expenses  of  the  committee  up  to  a  certain  percentage  on  the 


KEOKGANIZATION   OF   CORPORATIONS      429 

amount  of  securities  deposited.  It  is  usually  provided  that 
the  committee  may  at  any  time  terminate  the  agreement,  and 
also  to  allow  the  bondholders  to  terminate  it  by  a  certain 
vote.  The  effect  of  the  deposit  of  securities  is  to  constitute 
the  members  of  the  committee  trustees  for  the  depositors,  to 
form,  as  it  were,  a  temporary  corporation  for  the  attainment 
of  certain  objects. 

The  committee,  after  conference  with  bankers,  whose 
assistance  is  indispensable  to  the  consummation  of  a  plan 
of  reorganization,  after  examining  the  condition  of  the 
property,  its  assets  and  liabilities,  its  record  of  earnings, 
and  also  after  conferring  with  large  shareholders  and  cred- 
itors, announce  a  plan  of  reorganization.  This  plan  they  may 
either  announce  on  behalf  of  themselves  or  through  bankers 
or  individuals  whom  they  may  designate  as  reorganization 
managers.  For  example,  J.  P.  Morgan  &  Company  on  June 
1,  1909,  made  the  following  announcement  to  the  holders 
of  debenture  stock,  Preferred  stock  A,  Preferred  stock  B, 
and  Common  stock  of  the  Chicago,  Great  Western  Railway 
Company : 

"  At  the  request  of  the  London  Committee  for  Debenture 
Stock  of  the  New  York  Committee  for  Debenture  Stock,  and 
of  the  New  York  Committee  for  Preferred  Stock  A,  Pre- 
ferred Stock  B,  and  Common  Stock,  the  undersigned  have 
consented  to  act  as  Reorganization  Managers  in  carrying  out 
a  Plan  for  the  Reorganization  of  the  Chicago  Great  Western 
Railway  Company." 

So  far  as  the  securities  affected  by  the  plan  have  been 
lodged  with  a  committee,  the  assent  of  the  committee  to  the 
plan  is  held  to  be  binding  on  the  depositing  bond  or  stock- 
holders unless  they  signify  their  dissent  within  the  time  named 
in  the  agreement  with  the  committee,  by  withdrawing  their 
securities.  Holders  of  securities  which  have  not  been  deposited 
are  given  a  certain  time  to  consent  to  the  plan.  This  time 
limit  is  often  extended,  but  unless  the  deposits  are  made 


430  COEPOKATION   FINANCE 

within  the  time  stipulated  by  the  committee,  nonassenting 
bond  or  stockholders  are  held  to  be  excluded  from  the  benefits 
of  the  plan  and  must  take  their  chances  like  anyone  else  in 
a  foreclosure  sale. 

Coming  now  to  the  consideration  of  the  reorganization 
plan,  we  find  that  the  property  may  be  either  returned  to  its 
former  owner,  or  it  may  be  transferred  under  foreclosure 
sale  to  a  new  company.  It  sometimes  happens  that  there  are 
distinct  advantages  in  reorganization  without  foreclosure  sale, 
employing  the  same  company  which  controlled  the  property 
before  the  default.  Companies  may  have  valuable  privileges 
in  the  form  of  exemption  from  taxation,  or  authorization 
from  the  state  to  engage  in  enterprises  such  as  the  carrying  on 
of  coal  mining  and  railroad  operations  under  the  same  organ- 
ization, which  may  have  been  forbidden  to  corporations  since 
a  particular  charter  was  granted.  In  such  cases,  the  reorgan- 
ization plan  usually  contemplates  the  return  of  the  prop- 
erty to  the  existing  company.  The  Philadelphia  &  Eeading 
Railroad  Company,  for  example,  went  through  two  reorgan- 
izations because  its  charter  privileges  were  too  valuable  to  be 
surrendered. 

The  usual  method  is,  however,  to  organize  a  new  company 
in  which  is  vested  after  foreclosure  sale  such  portions  of 
the  property  of  the  old  company  as  it  is  thought  wise  to 
retain,  and  which  either  assumes  the  obligations  of  the  old 
company  in  their  original  form,  or  secures  such  modifications 
and  reductions  in  their  amount  as  are  necessary  to  the  suc- 
cess of  the  new  company.  The  advantage  of  this  method  is 
that,  by  the  foreclosure  sale,  all  the  rights  of  nonassenting 
security  holders  are  extinguished,  and  the  new  company  is 
placed  in  complete  control  of  the  property  which  it  desires. 
It  is  customary,  even  when  a  new  company  is  employed,  to 
use  a  name  closely  resembling  that  of  the  old  company.  A 
raWroad  company,  for  example,  will  be  succeeded  by  a  rail- 
way/ company,  and  vice  versa. 

After  the  new  company  is  organized,  it  authorizes  the 
issue  of  certain  securities.     The  Chicago  &  Great  Western 


EEOKGANIZATION   OF   COKPOEATIONS      431 

'Railway  ^  Company,  the  successor  of  the  Chicago  &  Great 
Western  Uailroad  ^  Company,  authorized  $38,000,000  of  first 
mortgage,  fifty  year  four  per  cent  bonds,  $50,000,000  of 
four  per  cent  preferred  stock,  and  $46,000,000  of  common 
stock.  The  Western  Maryland  was  reorganized  by  the  for- 
mation of  a  new  company  which  took  over  the  property  of 
the  old  company  subject  to  its  first  mortgage  and  its  under- 
lying and  divisional  bonds,  and  which  authorized  $10,000,000 
of  noncumulative  four  per  cent  preferred  stock,  and  $60,- 
000,000  of  common  stock.  The  securities  of  this  new  com- 
pany are  now  offered  for  subscription.  The  subscriptions  are 
paid  either  in  cash,  or  with  the  securities  of  the  old  company, 
or,  in  rare  instances,  with  the  guarantee  of  another  corpora- 
tion. In  the  fulfillment  of  the  conditions  of  subscription,  the 
objects  of  reorganization  are  accomplished. 

Advantage  is  usually  taken  of  this  opportunity  to  simplify 
the  capitalization  of  the  company.  Especially  has  this  been 
done  in  reorganizations  of  large  railway  companies.  The 
formation  of  a  new  company  which  issues  its  bonds  and  stock 
in  exchange  for  those  of  the  old,  makes  possible  the  concen- 
tration and  simplification  of  the  capitalization.  It  unites 
branch  line  and  terminal  certificates,  car  trust  certificates, 
equipment  bonds  and  other  obligations  under  single  issues 
which  are  more  easily  managed,  better  secured  and  of  higher 
values  than  those  which  they  displace.  The  property  of  the 
Northern  Pacific  Railway  Company,  for  example,  before  its 
last  reorganization,  was  owned  by  fifty-four  corporations 
which  had  issued  $380,000,000  of  stocks  and  bonds.  The 
circular  of  the  reorganization  committee  described  the  old 
plan  of  capitalization  as  follows: 

"  As  it  now  stands,  the  system,  in  its  form  of  incorpora- 
tion and  capitalization,  is  a  development  without  method  or 
adequate  preparation  for  growth.  Scarce  any  single  security 
is  complete  in  itself.  The  main  line  mortgage  covers  neither 
feeders  nor  terminals.     The  terminal  mortgages  may  be  be- 

1  Italics  axe  the  author's. 


432  COKPOKATION   FINANCE 

reft  of  their  main  line  support.  The  branch  line  bonds  are 
dependent  upon  the  main  line  for  interchange  of  business, 
and  the  main  line  owes  a  large  part  of  its  business  to  the 
branch  lines." 

The  plan  of  reorganization  of  this  company  reduced  the 
number  of  these  obligations,  and  greatly  simplified  the  cap- 
italization of  the  company  by  subjecting  the  entire  system  to 
the  lien  of  two  bond  issues,  one  following  the  other.  Sink- 
ing fund  provisions,  which  have  proven  embarrassing  to  the 
corporation,  may  also  be  eliminated.  An  adequate  bond  re- 
serve may  be  provided  under  which,  with  proper  restrictions, 
future  issues  of  bonds  for  the  capital  needs  of  the  company 
may  be  made.  The  company  may  also  save  in  the  exchange 
of  securities  by  retiring  high  interest  bonds  issued  on  branch 
lines  where  the  security  is  not  perfect,  with  lower  interest 
bonds  secured  by  mortgage  upon  the  entire  property.  All 
these  methods  of  reorganizing  the  capital  account  have  been 
fully  explained  in  Chapter  X-XI.  They  are  freely  employed 
in  the  reorganization  of  bankrupt  corporations,  because  the 
transfer  of  the  property  from  one  company  to  another  fur- 
nishes an  excellent  opportunity  for  such  readjustments. 

A  more  important  use  is  found  for  the  securities  of  the 
new  company  in  providing  the  cash  required  in  the  reorgan- 
ization, and  making  the  necessary  reduction  in  fixed  charges. 
In  most  reorganizations,  as  already  observed,  a  large  amount 
of  cash  must  be  provided.  The  cash  requirements  of  the 
Baltimore  &  Ohio  reorganization  plan,  for  example,  in  1896, 
amounted  to  $36,092,000.  The  reorganization  managers  of 
the  Erie  had  to  provide  $19,344,000.  More  recently,  the 
Chicago  Great  Western,  a  comparatively  small  company,  pro- 
vided $24,892,274  in  its  reorganization.  This  cash  is  ob- 
tained by  subscription  to  the  bonds  and  stock  of  the  new 
company. 

Efforts  are  first  made  to  interest  the  stockholders  who 
are  invited  to  participate  in  the  reorganization.  To  the  com- 
mittee  in   charge    of   the   reorganization    is   presented   this 


EEOKGANIZATION   OF   COKPOKATIONS      433 

problem :  "  If  we  take  over  the  property  at  a  foreclosure  sale, 
and  exclude  the  former  stockholders,  it  will  be  necessary 
for  us  to  provide  the  cash  required.  The  money  can  prob- 
ably be  raised,  it  is  true,  by  the  sale  of  first,  or  first  and 
refunding  mortgage  bonds,  but  since  one  object  of  reorganiza- 
tion is  to  reduce  rather  than  increase  the  debt  of  the  com- 
pany, it  is  desirable  to  keep  down  the  new  bonds  issued  to 
the  lowest  possible  figure.  The  only  practical  alternative  is 
to  induce  the  stockholders  of  the  bankrupt  company  to  fur- 
nish the  funds  required." 

The  offer  to  subscribe  to  the  securities  of  the  new  com- 
pany is  made  to  the  stockholders  in  one  of  two  forms.  They 
may  be  told  that  their  company  has  failed;  it  is  unable  to 
pay  its  debts,  its  creditors  have  liens  upon  all  its  properties. 
Unless  the  stockholders  are  prepared  to  furnish  the  money 
necessary  to  pay  these  debts,  the  property  must  be  sold  by  the 
court  and  the  stockholders  will  lose  all  chance  to  recover 
their  loss.  In  the  foreclosure  sale,  th^  various  evidences  of 
debt,  no  matter  how  much  their  interest  may  be  in  default, 
or  how  worthless  they  may  be  in  the  market,  will  count,  as 
against  any  inferior  lien,  at  100  cents  on  the  dollar.  There- 
fore, if  the  stockholders  desired  to  compete  at  the  sale,  they 
would  be  at  a  hopeless  disadvantage,  since  it  would  be  neces- 
sary for  them  to  match,  dollar  for  dollar,  with  cash,  the  vari- 
ous bonds  which  will  be  presented  as  a  means  of  payment  by 
the  creditors.  The  creditors,  therefore,  control  the  situation. 
They  propose  to  organize  a  new  company  to  take  over  the 
property  of  the  bankrupt  corporation,  since  they  realize  the 
necessity  of  keeping  the  property  together. 

The  creditors,  however,  do  not  desire  to  take  undue  ad-, 
vantage  of  their  position.  They  will  give  to  the  stock- 
holders the  privilege  of  joining  with  them  in  this  new  com- 
pany. They  make  to  the  stockholders  the  following  offer: 
to  sell  them  preferred  stock  in  the  new  company  for,  say, 
$20  per  share,  and  common  stock  for  $10  a  share.  "We 
have  every  reason,"  they  say,  "to  believe  that  with  the  in- 
debtedness paid,  funded  or  reduced  within  a  conservative 


434  COKPOKATION   FINANCE 

estimate  of  earnings,  and  with  good  management,  the  new 
company  will  be  more  successful  than  the  old.  We  are  con- 
fident that  if  you  purchase  stock  in  the  new  company  on 
the  basis  proposed,  you  will  have  no  reason  to  regret  your 
action." 

This  was  the  proposition  which,  in  substance,  was  made 
to  the  stockholders  of  the  Westinghouse  Electric  &  Manu- 
facturing Company,  on  April  8,  1908.  The  stockholders  com- 
mittee of  this  company  sent  out  a  circular  letter  outlining 
a  plan  of  reorganization  in  substance  as  follows:  Certain 
bonds  of  the  company  were  to  remain  undisturbed.  The 
floating  debt  was  in  part  to  be  converted  into  stock  and  in 
part  funded  into  bonds  and  notes.  The  stockholders  were 
to  subscribe  at  par  for  $6,000,000  of  new  stock.  The  propo- 
sition to  the  stockholders  was  as  follows: 

"  The  chief  difficulty  with  the  company  and  the  principal 
cause  of  the  receivership  are  found  in  the  fact  that,  as  the 
result  of  the  rapid  expansion  of  its  business,  too  large  a 
proportion  of  its  investment  is  represented  by  debt.  If  a 
substantial  reduction  can  be  made  in  the  debt  by  the  sale 
of  additional  stock,  it  is  believed  that  the  receivership  can 
be  promptly  terminated  with  every  prospect  of  the  company 
entering  upon  a  career  of  renewed  prosperity.  On  this  point 
the  committee,  of  which  Mr.  Jarvie  is  chairman,  in  their 
circular  of  April  2,  1908,  say : 

"  *  The  committee  believe  that  if  the  conduct  of  the  busi- 
ness can  promptly  be  restored  to  the  stockholders  under  the 
direction  of  a  strong  board  of  directors,  the  company  will 
continue  to  make  substantial  earnings.  On  the  other  hand, 
there  can  be  no  doubt  that  a  continuation  of  the  receivership 
for  a  considerable  time,  and  a  forced  liquidation  of  the  as- 
sets, would  be  disastrous  to  the  creditors  as  well  as  to  the 
stockholders.' 

"The  Merchandise  Creditors'  Committee  have  shown 
their  confidence  in  the  company  and  its  future  by  under- 
taking to  secure  the  exchange  of,  at  least,  $4,000,000  of  the 


EEORGANIZATION   OF   CORPORATIONS      435 

company's  floating  debt  for  '  assenting  stock/  at  par.  They, 
however,  impose  the  condition  that  the  remaining  $6,000,000 
of  the  $10,000,000  of  subscriptions  required  to  terminate  the 
receivership  and  place  the  company  in  a  safe  position  shall 
be  furnished  by  the  stockholders.  It  is  for  the  purpose  of 
securing  from  stockholders  subscription  to  this  $6,000,000 
of  stock  that  the  undersigned  committee  has  been  formed. 
"The  holders  of  the  preferred  and  common  stock  of  the 
company  are,  therefore,  asked  to  subscribe  for  'assenting 
stock'  of  the  company  at  par,  at  the  rate  of  at  least  one 
share  of  new  stock  for  every  four  shares  (or  fraction  thereof) 
of  existing  stock.  Such  subscriptions  are  to  be  payable  in 
the  following  installments: 

25  per  cent  on  May  25,  1908, 

20  "      "      "   August  1,  1908, 

20  "       "       "    November,  1, 1908, 

20  "       "       "    January  1,  1909, 

15  "       "       "    April  1,  1909. 

The  deferred  payments  are  to  bear  interest  at  the  rate  of 
six  per  cent  per  annum,  with  the  privilege  to  subscribers  to 
pay  their  subscriptions  in  full  at  any  time. 

"  The  Merchandise  Creditors'  plan  cannot  be  carried  into 
effect  unless  the  stockholders  protect  themselves  by  subscrib- 
ing pro  rata  for  their  shares  of  this  new  stock.  If  these  sub- 
scriptions are  not  forthcoming,  the  inevitable  result  will  be 
that  the  Readjustment  Committee,  which  was  organized  for 
the  protection  of  creditors,  will  be  forced  to  reduce  the  debt 
of  the  company  to  judgment,  bring  about  a  forced  sale  of 
the  property  and  its  acquisition  by  a  new  corporation  or- 
ganized in  the  interest  of  creditors.  Such  a  course  would 
result  in  enormous  loss  which  would  fall  chiefly  upon  the 
stockholders  of  the  company.  That  loss  can  be  avoided  only 
by  the  cooperation  of  stockholders  in  promptly  subscribing 
for  a  sufficient  amount  of  new  stock  to  insure  an  early  ter- 
mination of  the  receivership. 


436  COKPOKATION  FINANCE 

"The  committee  wish  to  lay  special  emphasis  upon  the 
fact  that  the  success  of  this  plan  for  saving  the  company  for 
its  stockholders  requires  the  unanimous  compliance  of  stock- 
holders, however  small  their  holdings,  with  this  request  for 
subscriptions.  The  ownership  of  the  stock  of  the  company 
is  divided  among  about  4,000  stockholders,  the  average  hold- 
ing (excluding  the  holdings  of  the  Security  Investment  Com- 
pany and  its  president)  being  only  about  eighty-three  shares 
(par  value,  $50).  Most  of  the  stock  owned  by  the  Security 
Investment  Company  has  been  pledged  as  collateral  in  com- 
paratively small  amounts  with  a  large  number  of  banks 
which  are  being  asked  to  subscribe  to  the  new  stock  in  propor- 
tion to  their  respective  holdings." 

Subscriptions  to  the  stock  of  the  Westinghouse  Electric 
&  Manufacturing  Company  were  largely  influenced  by  this 
express  threat  that  failure  to  procure  the  required  amount 
would  subject  the  stockholders  to  the  danger  of  foreclosure 
sale. 

The  situation  of  the  Westinghouse  Electric  &  Manufac- 
turing Company  is,  however,  different  from  that  of  most  bank- 
rupt corporations.  With  this  company,  the  trouble  was  chiefly 
due  to  inadequate  working  capital  which  resulted  in  an  exces- 
sive amount  of  funded  debt  calling  for  the  payment  of  both 
principal  and  interest  at  a  time  when  financing  could  not  be 
done.  The  reorganization  of  the  Westinghouse  Company  re- 
quired nothing  more  than  the  funding  of  this  current  debt  on 
which  the  company  was  abundantly  able  to  pay  interest.  The 
stockholders'  interest  in  the  property  was  plain.  Even  dur- 
ing the  receivership,  the  stock  never  fell  below  $8.75,  (par 
$50)  which  indicated  a  considerable  margin  of  value  after 
the  debts  were  paid. 

In  most  cases,  however,  bankruptcy  has  been  due  to  the 
failure  of  the  company  to  earn  interest  on  its  funded  debt. 
If  the  company  cannot  earn  enough  to  pay  interest  on  its 
bonds,  then  its  property  is  not  worth  the  amount  of  its  debts, 
and  there  is  nothing  left  for  the  stockholders.     Their  in- 


REORGANIZATION   OF   CORPORATIONS      437 

terest  in  the  property  has,  long  before  the  reorganization, 
entirely  disappeared.  They  have  already  been  "  wiped  out." 
To  stockholders  in  this  situation  a  proposition  that  they 
should  subscribe  to  stock  in  a  new  company  at  the  rate  of 
$10,  $15,  or  $20  per  share  might  be  unattractive.  The  re- 
sponse of  many  stockholders  to  such  a  proposition  would  be 
an  emphatic  negative.  They  would  inform  the  reorganiza- 
tion committee  that  they  did  not  propose  to  throw  good 
money  after  bad;  that  they  did  not  care  to  make  a  new  in- 
vestment in  the  company  with  which  they  had  fared  so  badly ; 
that,  although  the  claims  of  the  reorganization  committee 
as  to  the  future  of  the  company  might  be  borne  out  by  re- 
sults, for  their  part,  they  would  prefer  to  await  the  mate- 
rialization of  those  results,  rather  than  risk  any  more  of 
their  money  in  a  venture  which  had  proven  so  disastrous. 

When  money  is  to  be  raised  from  stockholders  where 
there  is  no  equity  in  the  property  which  they  would  naturally 
desire  to  retain,  the  proposition  has  frequently  been  pre- 
sented to  them  in  a  different  form.  Instead  of  being  invited 
to  subscribe  to  stock  of  a  new  company,  the  offer  takes  the 
form  of  a  proposition  that  they  should  pay  an  "  assessment " 
upon  their  stock,  "go  through  the  reorganization,"  and  re- 
cover, in  the  increasing  profits  of  the  company,  the  losses 
which  they  have  sustained.  In  the  Chicago  &  Great  West- 
ern reorganization  plan,  for  example,  the  conditions  of  par- 
ticipation in  the  plan  were  set  forth  to  the  stockholders  as 
follows : 

"  Participation  under  the  plan  by  holders  of  the  several 
classes  of  stock  is  dependent  on  the  deposit  of  the  stock  cer- 
tificates with  the  undersigned,  within  the  period  limited  there- 
for. The  plan  embraces  only  the  stocks  so  deposited.  No  cer- 
tificate for  any  stock  of  any  class  will  be  received  on  deposit 
unless  in  negotiable  form. 

"Debenture  Stock  and  Preferred  Stock  A  are  to  be  re- 
ceived without  payment  as  stated  in  the  Plan. 

"  Depositors  of  Preferred  Stock  B  must  pay  $15  in  re- 
spect of  each  share  of  such  Preferred  Stock  B  so  deposited, 


438  CORPOKATION   FINANCE 

and  will  be  entitled  to  obtain  from  the  Syndicate  mentioned 
in  the  Plan,  Preferred  Stock  voting  trust  certificates  of  the 
New  Company  when  issued,  equal  at  par  to  such  payment, 
and  also  Common  Stock  voting  trust  certificates  of  the  New 
Company,  when  issued,  to  an  aggregate  amount  at  par  equal 
to  sixty  per  cent  of  the  par  value  of  their  present  Preferred 
Stock  B  so  deposited. 

"  Depositors  of  Common  Stock  must  pay  $15  in  respect 
of  each  share  of  such  Common  Stock  so  deposited,  and  will 
be  entitled  to  obtain  from  the  Syndicate,  hereinafter  men- 
tioned. Preferred  Stock  voting  trust  certificates  of  the  New 
Company,  when  issued,  equal  at  par  to  such  payment,  and 
also  Common  Stock  voting  trust  certificates  of  the  new 
Company,  when  issued,  to  an  aggregate  amount  at  par  equal 
to  forty  per  cent  of  the  par  value  of  their  present  Common 
Stock  so  deposited." 

A  careful  examination  of  this  statement  will  show  the 
difference  in  form,  although  not,  as  we  shall  see,  in  sub- 
stance, between  the  proposition  of  an  assessment  and  the 
proposition  of  a  new  subscription.  The  payments  of  cash 
are  to  be  made  in  respect  of  and  in  connection  with  the  de- 
posit of  common  and  preferred  stock  under  the  plan.  The 
stockholder  is  informed  that,  if  he  will  make  a  contribution 
on  account  of  his  present  stockholdings,  he  will  be  allowed 
^to  receive  stock  in  the  new  company.  He  does  not,  on  the 
face  of  things,  'pay  for  the  stock  in  the  new  company — that 
is  given  him  in  exchange  for  his  old  stock.  He  pays  an 
"  assessment "  on  his  old  stock,  and,  on  account  of  this  "  as- 
sessment," he  becomes  entitled  to  receive  new  stock. 

The  proposition  to  the  stockholders  of  the  old  company 
that  they  should  subscribe  to  stock  of  the  new  company  is  put 
something  as  follows  when  a  subscription  is  styled  an  assess- 
ment: "Your  company  is  bankrupt;  its  creditors  are  in 
position  to  take  the  property,  and  they  will  take  the  property 
unless  a  certain  amount  of  cash  is  raised.  The  creditors  do 
not,  however,  desire  to  exclude  stockholders  from  participa- 


EEOKGANIZATION   OF   COKPOKATIONS      439 

tion  in  the  reorganization,  but  they  must  look  to  the 
stockholders  to  furnish  the  necessary  money  by  paying  a 
small  assessment  on  the  par  value  of  their  present  holdings. 
If  you  will  pay  this  assessment,  you  will  be  allowed  to  ex- 
change your  certificates  of  stock  in  the  old  company  for  a 
certain  number  of  shares  in  the  new  company,  and  you  will 
receive  stock  in  addition  to  the  amount  of  the  assessment." 

This  proposition,  it  is  evident,  is  precisely  similar  to  the 
one  first  mentioned.  It  is  an  oifer  of  stock  in  a  new  company. 
But,  while  many  stockholders  in  a  bankrupt  and  discredited 
corporation  will  not  accept  a  proposition  when  presented 
to  them  as  a  subscription,  when  designated  as  an  "  assess- 
ment "  on  the  stock  which  they  already  own,  they  have  very 
generally  accepted  the  proposition  of  reorganization  com- 
mittees, have  paid  their  assessments,  and  received  stock  in 
the  new  concern.  The  second  form  of  the  subscription 
proposition  appeals  to  the  stockholders  while  the  first  does 
not.  The  "  assessment  "  'proposition  presents  to  the  stock- 
holder the  idea  of  an  unfinished  transaction.  He  hopes 
that,  with  one  more  effort,  the  payment  of  $10  or  $15  per 
share,  he  can  recover  from  the  company  the  money  which 
he  has  lost.  The  "  assessment "  proposition  offers  him  ap- 
parently the  opportunity  to  recoup  himself,  to  justify  to 
himself  his  judgment  of  the  value  of  the  stock  in  which,  up 
to  the  present  time,  he  has  been  so  grievously  disappointed. 
By  employing  this  method  of  calling  a  subscription  to  stock 
in  a  new  company  an  "  assessment "  on  stock  in  an  old 
company,  reorganization  committees  have  been  able  to  obtain 
large  amounts  of  money  from  stockholders,  whereas  if  they 
had  asked  the  stockholders  to  subscribe  to  stock  in  a  new 
company,  they  would  probably  have  been  much  less  successful. 

The  assessments  of  stockholders  are  usually  underwritten, 
a  syndicate  being  organized  to  pay  the  "  assessments,"  and 
to  take  the  stock  of  those  holders  who  do  not  participate  in 
the  plan.  The  commission  paid  to  this  syndicate  varies,  of 
course,  with  the  risk  which  they  assume,  but  the  existence 
of  the  syndicate  brings  pressure  to  bear  upon  the  stockholder 


440  COKPOKATION   FINANCE 

by  assuring  him  that  others  stand  ready  to  accept  apparently 
the  same  terms  which  are  offered  to  him.  In  1895,  for 
example,  the  final  Atchison  reorganization  plan  announced 
the  following: 

"  A  contract  has  been  made  with  a  syndicate  to  furnish 
an  amount  of  money  equal  to  the  assessments  of  nonassenting 
or  defaulting  stockholders,  and  such  syndicate,  by  such  pay- 
ment, shall  take  the  place  of  the  nonassenting  or  defaulting 
stockholders,  and  shall  be  entitled  to  receive  the  new  common 
and  preferred  stock,  which  nonassenting  or  defaulting  stock- 
holders would  have  been  entitled  to  receive  if  they  had  de- 
posited their  stock  and  paid  their  assessment  in  full."  The 
syndicate  may  actually  purchase  the  new  stock  and  offer  it 
to  those  stockholders  who  pay  their  assessments,  thus  making 
an  exceptionally  forcible  appeal.  By  employing  this  method 
of  approach,  reorganization  managers,  especially  in  railway 
reorganizations,  have  been  remarkably  successful  in  paying 
off  most  of  the  floating  debt  without  resorting  to  the  sale 
of  bonds. 

The  difference  between  a  reorganization  "  assessment "  and 
a  subscription  to  new  stock  is  only  in  form;  in  substance 
they  are  the  same  thing.  When  stock  is  full  paid,  it  is  not 
liable  to  any  assessment.  A  stockholder  may  have  only  paid 
$20  a  share  for  his  full  paid  stock,  but  the  corporation  has 
no  right  to  demand  any  more  from  him.  Any  further  pay- 
ments to  the  company  are  at  his  own  pleasure.  And  yet, 
so  imperfect  is  the  knowledge  possessed  by  the  average 
stockholder  of  his  rights  and  obligations,  that  he  is  apt  to 
feel,  when  an  assessment  proposition  is  made  to  him,  that 
there  is  an  obligation  to  pay  the  assessment  and  take  the 
new  stock.  A  reorganization  assessment  is  looked  upon  as 
compulsory.  Stockholders  are  informed  that  if  they  refuse 
to  pay  they  are  "  debarred  from  all  participation  in  the 
reorganization,"  that  they  "lose  all  chance  to  recoup  their 
loss  from  their  share  in  subsequent  profits." 

An   examination   of   a   large   number   of   reorganization 

^  Italics  are  the  author's. 


REORGANIZATION   OF   CORPORATIONS      441 

plans  recently  promulgated,  however,  shows  that  "  assess- 
ments" are  now  being  stated  in  their  true  light  as 
subscriptions.  For  example,  the  reorganization  plan  of  the 
Newhouse  Mines  &  Smelters  under  date  of  June  1,  1909, 
states  that: 

"  In  order  to  furnish  the  necessary  working  capital  for 
development,  payment  of  debts,  expenses  of  foreclosure, 
reorganization  and  underwriting,  the  Stockholders  will  be 
required  to  subscribe  to  the  capital  stock  of  the  new  company 
and  to  pay  one  dollar  for  every  share  so  subscribed.  Every 
Stockholder  so  subscribing  will  receive  one  share  of  common 
stock  of  the  New  Company  for  each  share  now  held  by  him." 

It  is  impossible  to  approve  the  indirect  method  of  raising 
money  from  stockholders,  which  is  only  recently  being  aban- 
doned. The  stockholder  owes  nothing  to  the  reorganization 
managers,  or  to  the  creditors.  If  they  secure  his  participation 
in  the  new  company,  they  should  make  him  an  offer  of  a 
more  attractive  investment  than  he  can  obtain  elsewhere. 
Unless  the  payment  of  an  assessment  on  stock  of  a  bankrupt 
corporation  gives  the  stockholder,  who  desires  to  continue  his 
interest  in  the  company,  the  new  stock  at  a  lower  figure  than 
that  at  which  he  can  purchase  it  in  the  open  market,  he 
should  allow  the  creditors  to  advance  the  money  necessary, 
and  buy  the  stock  after  the  reorganization  has  been  com- 
pleted. While  by  adopting  such  a  course  he  may  be  "  de- 
barred from  all  participation  in  the  reorganization,"  he  does 
not  "  lose  all  chance  to  recoup  his  losses  from  his  share  in 
the  subsequent  prosperity."  Dr.  Stuart  Daggett,  in  his  book 
"  Railroad  Reorganization,"  ^  gives  a  list  of  eight  reorganiza- 
tions in  which  the  common  stock  was  assessed,  together  with 
the  price  of  the  stock  one  month  after  reorganization,  and 
six  months  after  reorganization.  In  every  case  the  stock 
could  have  been  purchased  in  the  open  market  directly  after 
the  reorganization  at  a  lower  price  than  it  was  purchased 
from  the  reorganization  managers.  It  is  desirable  that  stock- 
holders should  cooperate  in  making  the  reorganization  plan 

'  P.  353. 


442  CORPOKATION   FINANCE 

a  success,  but  the  proposition  should  be  presented  to  them 
in  its  true  light,  and  not  under  the  guise  of  an  obligation  or 
a  necessity. 

The  offer  to  stockholders  if  foreclosure  is  not  involved  in 
the  reorganization  plan  is  usually  more  liberal  than  when 
the  threat  of  foreclosure  can  be  issued  to  induce  subscrip- 
tions. If  the  method  of  foreclosure  is  not  to  be  employed,  then 
the  stockholders  must  be  persuaded  into  the  subscription  by 
an  attractive  offer.  The  adjustment  plan  of  the  Seaboard 
Air  Line  Eailway,  which  was  carried  through  without  fore- 
closure, provided  the  cash  required  by  the  sale  of  $18,000,000 
of  par  value  of  cumulative  five  per  cent  income  bonds,  called 
adjustment  bonds.  These  were  offered  for  subscription  at 
seventy  per  cent  of  their  par  value  to  the  extent  of  thirty 
per  cent  of  the  par  value  of  their  existing  holdings.  A  syn- 
dicate was  organized  which,  for  a  commission  of  five  per  cent 
on  the  par  value  of  $18,000,000  of  bonds,  offered  to  the  stock- 
holders, guaranteed  to  purchase  at  this  price  any  bonds  that 
might  not  be  subscribed  and  paid  for  by  the  stockholders. 
In  this  case  there  was  no  pressure  put  upon  the  stockholders 
to  furnish  any  capital  to  the  company.  An  attractive  offer 
was  made  to  th^m,  and  their  acceptance  of  the  offer  was 
guaranteed  by  responsible  bankers.  Wliether  they  subscribed 
or  not,  so  far  as  the  provision  of  cash  was  concerned,  the 
success  of  the  plan  was  assured. 

If,  or  to  the  extent  that  stockholders  will  not  advance 
money,  the  creditors  must  provide  the  funds  required  by  sub- 
scribing to  the  securities  of  the  new  company.  The  creditors 
of  a  bankrupt  company  are  potentially  in  the  position  of  own- 
ers. They  can  obtain  the  ^property  at  a  foreclosure  sale,  and 
if  they  cannot  persuade  or  coerce  the  stockholders  into  ad- 
vancing the  money  necessary  for  its  rehabilitation,  they  will 
be  obliged  to  take  over  the  property,  and  themselves  provide 
the  necessary  funds.  Eliminating  the  stockholders,  we  have 
now  to  consider  the  methods  by  which  creditors  finance  the 
cash  requirements  of  a  reorganization.  Several  conditions 
may  be  presented.    There  may  be  only  one  class  of  creditors, 


KEOKGANIZATION   OF   CORPOKATIONS       443 

the  holders  of  mortgage  bonds.  The  company  issuing  these 
bonds  has  defaulted,  and  receivers  have  been  appointed. 
These  receivers  have  made  certain  expenditures  for  the  benefit 
of  the  property,  and  certain  other  expenditures  are  necessary. 
The  stockholders  will  advance  no  more  money.  As  the  re- 
organization committee  of  the  Arnold  Print  Works  stated 
in  their  announcement  of  a  plan  of  reorganization : 

"  Eeorganization  with  fresh  capital  contributed  by  the 
present  stockholders  is  impracticable,  as  nearly  all  the  stock 
is  owned  by  Messrs.  Houghton  &  Gallup,  and  apart  from 
their  interest  in  this  stock  they  are  now  without  substantial 
bieans." 

The  creditors  in  such  a  situation  must  depend  upon  them 
selves.  They  organize  a  new  company  to  take  over  the  prop- 
erty, thereby  extinguishing  all  rights  of  stockholders  and 
any  minor  claims  of  current  indebtedness  which  may  be  out- 
standing. They  capitalize  this  new  company  according  to 
the  exigencies  of  the  situation.  They  may  subject  its  prop- 
erty to  the  lien  of  a  first  mortgage  bond  which  they  may 
either  take  themselves  or  sell  to  bankers,  obtaining  in  this 
manner  all  necessary  funds,  or  they  may  subscribe  to  the 
stock  of  a  new  company,  placing  no  funded  debt  upon  it. 
The  property  is  at  their  disposal;  they  can  use  it  to  support 
the  credit  of  the  company  as  it  may  be  necessary.  If  they 
advance  the  required  funds  themselves,  they  may  arrange  the 
capitalisation  of  the  new  company  in  any  way  they  see  fit. 
If,  however,  they  sell  the  securities  to  outsiders  they  must 
consult  the  wishes  of  the  subscribers. 

A  case  in  point  came  recently  under  the  writer's  observa- 
tion. A  water-power  company  had  underestimated  the  cost 
of  a  power  and  transmission  plant.  When  the  plant  was 
little  more  than  half  completed,  funds  were  exhausted.  Re- 
ceivers were  appointed  and  the  bondholders  eventually  bought 
in  the  plant  at  a  foreclosure  sale,  eliminating  the  stock  in- 
terest. It  was  now  necessary  to  provide  funds  to  complete 
the  plant.  The  following  plan,  after  prolonged  negotiations, 
was  presented  to  the  bondholders.    A  new  company  should  be 


V 


444  COKPOKATION   FINANCE 

organized  to  take  over  the  plant.  This  company  was  to  issue 
first  mortgage  five  per  cent  bonds  to  an  amount  sufficient  to 
complete  the  plant,  and  certain  of  the  bonds  were  to  be  held 
in  reserve  for  extensions.  The  old  bondholders  were  to  re- 
ceive noncumulative  preferred  stock  for  their  bonds,  and  the 
new  bonds  were  to  carry  with  them  all  the  common  stock  of 
the  company  as  a  bonus.  The  owners  of  the  plant  were 
offered  the  privilege  of  subscribing  to  the  new  bonds,  and 
receiving  their  pro  rata  share  of  the  common  stock.  The 
subscriptions  to  the  bonds  were  guaranteed  by  a  finance  com- 
pany, which  undertook,  for  a  commission,  to  take  the  bonds 
of  nonsubscribing  owners,  and  receive  their  share  of  the 
bonus  of  common  stock. 

Another  condition  may  arise;  there  may  be  secured  cred- 
itors and  unsecured  creditors,  commonly  known  as  floating 
debt  creditors.  We  have  already  seen  that  when  floating 
debt  is  amply  secured  by  collateral,  the  reorganization  plan 
must  provide  for  its  payment.  It  frequently  happens,  how- 
ever, that  the  floating  debt  is  unsecured.  The  Westinghouse 
Electric  &  Manufacturing  Company  at  the  time  of  its  fail- 
ure owed  $5,000,000  for  merchandise,  and  $8,000,000  to 
banks,  for  all  of  which  there  was  no  special  security.  In 
such  a  case,  the  holders  of  the  floating  debt,  if  the  amount 
is  large,  in  order  to  save  something  from  the  wreck,  must 
advance  the  money  required  to  put  the  company  on  its  feet. 
They  cannot  ask  the  bondholders  to  make  sacriflces,  because, 
if  the  bondholders  advance  the  necessary  money,  they  may 
insist  on  retaining  the  stock  of  the  new  company.  As  for 
their  own  claims,  the  floating  debt  creditors,  in  case  they 
manage  the  reorganization  and  provide  the  necessary  funds, 
and  in  case,  also,  they  do  not  disturb  the  position  of  the  bond- 
holders and  safeguard  the  bondholders'  interests  in  the  re- 
organization, may  arrange  the  capitalization  of  the  new  com- 
pany as  they  please.  In  the  Westinghouse  reorganization, 
for  example,  already  referred  to,  where  the  stockholders  ad- 
vanced the  necessary  funds,  the  holders  of  the  company's 
notes,  for  fifty  per  cent  of  their  claims,  received  convertible 


EEOKGANIZATION   OF   COEPOKATIONS      445 

five  per  cent  debenture  bonds  of  the  company  which  were  in 
its  treasury,  and  for  the  other  fifty  per  cent  of  their  claims, 
fifteen-year  five  per  cent  notes  of  the  company  bearing  five 
per  cent  interest.  As  for  the  batiks,  if  they  objected  to  wait- 
ing so  long  for  repayment,  they  were  offered  the  privilege  of 
taking  amounts  equal  to  thirty  per  cent  of  their  claims  in 
serial  bonds  due  in  four,  five,  and  six  years,  on  condition 
that,  for  the  balance  of  the  fifty  per  cent,  they  should  accept 
stock  of  the  company  at  par.  In  this  case  the  floating  debt 
creditors  were  able  to  negotiate  successfully  with  the  stock- 
holders, on  account  of  the  large  equity  in  the  property.  If, 
however,  the  stockholders  had  not  advanced  the  necessary 
funds,  it  would  have  been  necessary  for  the  holders  of  the 
floating  debt  to  themselves  subscribe  to  a  sufficient  amount 
of  stock  in  the  new  company  to  provide  the  cash  required, 
taking  in  addition  stock  for  their  own  claims,  and  eliminat- 
ing the  stockholders. 

Occasions  may  arise  where  the  bondholders  and  the  float- 
ing debt  creditors,  when  no  money  can  be  obtained  from 
stockholders,  divide  the  burdens  of  the  reorganization  be- 
tween them,  and  partition  the  stock  of  the  company  in  return 
for  their  cash  advances.  Even  if  the  bondholders  are  obliged 
to  take  charge  of  the  reorganization,  and  arrange  for  the 
financing,  they  may  not  eliminate  the  floating  debt  creditors, 
on  account  of  special  reasons.  It  may  be  possible,  for  ex- 
ample, to  arrange  with  some  outside  company  to  guarantee 
an  issue  of  second  mortgage  bonds  in  return  for  the  com- 
mon stock.  In  such  a  case  there  would  probably  be  no 
objection  to  the  floating  debt  creditors  receiving  preferred 
stock  in  the  reorganization  plan  without  cash  advances.  As 
a  rule,  however,  if  the  general  creditors  do  not  subscribe,  and 
if  suitable  arrangements  cannot  be  made  with  outside  inter- 
ests, then  the  bondholders  must  provide  the  money.  They 
will  usually  take  the  stock  of  the  new  company,  eliminating 
general  creditors  of  the  old  company  along  with  its  stock- 
holders. 

A   further  complication  enters  when  there   are   several 


446  COKPOEATION  FINANCE 

classes  of  bondholders,  as  well  as  different  floating  debt  in- 
terests, and  stockholders.  Suppose  stockholders  will  not  ad- 
vance money,  that  the  general  creditors  are  also  unwilling 
to  invest  in  the  securities  of,  the  new  company,  that  there  are 
first  mortgage  bonds  upon  the  property  whose  interest  has 
been  fully  earned  and  paid  by  the  receiver,  but  that,  in  addi- 
tion to  the  first  mortgage  bonds,  there  are  first  and  refunding 
bonds — that  is,  second  mortgage  bonds.  There  may  be  also 
debenture  bonds  and  car  trust  certificates.  In  such  a  situa- 
tion the  underlying  bonds  and  the  car  trust  certificates  can- 
not be  disturbed.  Their  security  is  ample,  and  there  is  no 
way  in  which  the  reorganization  committee  can  get  at  them. 
If  any  attempt  is  made  to  impose  upon  them  the  burden  of 
providing  the  money  required,  they  will  assert  their  rights 
at  foreclosure  sale,  taking  away  the  security  and  eliminating 
all  junior  securities.  The  holders  of  car  trust  certificates 
are  also  in  an  exceptionally  strong  position;  they  cannot  be 
asked  to  furnish  any  money.  The  holders  of  the  junior  bonds, 
with  or  without  the  participation  of  the  stockholders,  must 
here  provide  the  necessary  funds. 

A  case  in  point  is  that  of  the  reorganization  of  the  West- 
ern Maryland.  In  this  reorganization  plan,  securities  ag- 
gregating $50,951,950  remained  undisturbed.  Their  owners 
were  not  called  upon  to  provide  any  new  money.  The  $8,374,- 
160  of  cash  required  for  the  payment  of  maturing  obligations 
and  for  improvements  and  betterments  was  raised  by  the  sale 
of  $20,685,400  of  the  common  stock  of  the  company  to  a  bank- 
ers' syndicate  which  offered  this  stock  to  the  general  lien  and 
convertible  holders  and  to  the  stockholders.  The  junior  bond- 
holders were  offered  the  new  stock  at  forty  per  cent,  up  to  fifty 
per  cent  of  their  holdings,  and  the  holders  of  the  common 
stock  were  offered  the  new  common  stock  at  the  same  price,  up 
to  100  per  cent  of  their  holdings.  The  undisturbed  securities, 
in  this  case,  included  the  first  mortgage  bonds,  $42,518,000; 
divisional  bonds,  $6,200,000;  leased  line  bonds,  $1,659,300, 
and  leased  line  guaranteed  stock,  $574,650.  Interest  on  the 
first  mortgage  bonds  had  been  fully  earned,  and  there  was  no 


KEOKGANIZATION   OF   COKPORATIONS       447 

reason  for  asking  them  to  make  sacrifices.  The  divisional  and 
leased  line  bonds  and  guaranteed  stock  were  so  secured  that  an 
assertion  by  their  holders  of  their  rights  under  the  contracts 
with  the  Western  Maryland  Railroad  Company  might  have 
resulted  in  the  disruption  of  the  system.  It  was  necessary, 
therefore,  to  appeal  to  the  junior  securities,  and,  in  this  case, 
the  reorganization  managers  were  fortunate  in  securing  the 
cooperation  of  the  stockholders.  If  the  stockholders  had 
not  been  able  to  respond,  however,  then  it  might  have  been 
necessary  for  the  holders  of  the  first  mortgage  bonds  to  have 
taken  a  part  of  the  new  stock,  securing  the  cooperation  of 
the  general  lien  bondholders,  if  only  to  a  partial  extent,  by 
allowing  them  to  share  in  the  new  securities. 

I  have  suggested  only  a  few  of  the  complications  which 
may  arise.  A  reorganization  committee  may  be  confronted 
with  a  great  variety  of  situations.  Its  task  is  to  obtain  the 
money  on  the  best  terms  possible  with  due  regard  to  the 
legal  rights  of  all  interests  concerned.  The  only  rule  which 
seems  established  in  the  preparation  of  this  portion  of  a  re- 
organization plan  is  first  to  impose  the  burden  upon  the  stock- 
holders if  they  can  be  induced  to  assume  it,  next  in  order 
to  approach  holders  of  unsecured  floating  debts,  next  the 
junior  bondholders,  and  finally  the  holders  of  underlying 
securities.  The  appeal  in  each  case  is  strengthened  by  the 
implied  or  express  threat  of  complete  loss  to  follow  the  fore- 
closure sale  which  would  be  controlled  by  the  holders  of  the 
prior  claims. 

Finally,  if  money  is  to  be  raised  from  bankers  or  out- 
side investors,  a  proposition  must  be  made  which  is  attrac- 
tive to  them.  For  example,  if  there  are  first  mortgage  bonds 
which  cannot  be  disturbed,  and  if  it  is  proposed  to  obtain  the 
necessary  funds  without  "compulsory"  subscription  by  any 
of  the  old  interests,  by  the  sale  of  first  and  refunding  mort- 
gage bonds  to  a  bankers'  syndicate,  the  syndicate  may  insist 
upon  a  certain  amount  of  stock.  They  may  also  insist  that 
this  stock  shall  be  given  special  preference.  In  such  a  case, 
the  new  company  would  issue  preferred  stock  A  to  bankers. 


448  COKPORATION   FINANCE 

and  the  other  interests  would  take  B  preferred  and  common 
stock. 

We  have  already  observed  in  the  consideration  of  these 
several  cases  that  the  underwriting  syndicate  is  a  necessary 
feature  in  every  reorganization  plan.  The  commission  paid 
to  the  syndicate  will  vary.  In  some  cases  it  may  be  large. 
The  Western  Maryland  Syndicate,  we  have  seen,  was  to  re- 
ceive a  commission  of  five  per  cent.  In  the  reorganization 
plan  of  the  United  States  Shipbuilding  Company,  the  com- 
mittee announced  that  it  had  entered  into  an  agreement  with 
the  Morton  Trust  Company  and  Thomas  F.  Eyan  for  the 
purchase  and  sale  of  the  entire  issue  of  $3,000,000  collateral 
trust  sinking  fund  six  per  cent  bonds  at  a  price  of  87^,  so 
as  to  guarantee  the  cash  requirements  of  the  plant.  These 
bonds  were  offered  by  the  syndicate  to  the  holders  of  the 
existing  bonds.  The  low  price  offered  the  chance  of  a  large 
profit  to  the  syndicate. 

The  needs  of  the  present  have  now  been  provided  for, 
current  indebtedness  has  been  paid,  and  provision  has  been 
made  for  sufficient  capital  to  bring  up  the  plant  to  a  condi- 
tion of  efficiency.  The  committee  on  reorganization  now 
addresses  itself  to  the  task  of  reducing  fixed  charges  so  that 
they  will  come  well  within  conservative  estimate  of  the  net 
earnings.  We  have  already  discussed  the  method  by  which 
the  limit  of  fixed  charges  in  the  new  company  is  to  be  fixed. 
This  limit  is,  as  already  pointed  out,  the  minimum  net  earn- 
ings of  the  company.  The  amount  is  usually  based  on  the 
experience  of  the  receiver,  although  some  allowance  may  be 
made  for  an  anticipated  improvement  in  earnings.  For  ex- 
ample, in  the  Atchison  reorganization  of  1894  it  was  esti- 
mated that  the  minimum  earnings  of  the  property  from  1891 
to  1894  were  $5,204,880,  and  the  fixed  charges  proposed  for 
the  new  company  were  $4,528,547.  The  lowest  net  earnings 
which  the  Union  Pacific  had  ever  reported  had  been  $4,315,- 
077.  The  interest  on  the  bonds  issued  by  the  new  company 
which  took  over  the  property  in  1897,  was  placed  at  $4,000,- 
000;  the  net  earnings  for  the  Northern  Pacific  in  1895,  the 


REORGANIZATIOK   OF   CORPORATIONS      449 

smallest  earnings  for  eight  years,  were  $6,052,660;  the  fixed 
charges  of  its  successor  were  placed  at  $6,015,846.  Dr.  Dag- 
gett,^ in  his  summary  of  the  results  of  a  number  of  railroad 
reorganizations,  states  that  the  fixed  charges  in  seven  large 
reorganizations  from  1893  to  1898  were  reduced  from  $65,- 
984,219  to  $45,576,984.  It  is  now  well  recognized  that  un- 
less this  principle  of  reducing  fixed  charges  below  the  lowest 
point  to  which  net  earnings  have  ever  fallen  is  followed, 
there  is  danger  that  the  work  will,  at  some  later  period  of 
depression,  have  to  be  done  over  again.  This  principle  was 
not  recognized  in  many  of  the  reorganizations  prior  to  1893. 
Since  that  time,  however,  it  has  been  generally  accepted  and 
may  now  be  taken  as  an  almost  invariable  rule. 

The  fixed  charges  of  a  corporation  may  be  divided  into 
rental  charges  and  interest  charges.  The  charges  for  rentals 
can  be  more  easily  reduced  than  the  charges  for  interest. 
As  long  as  a  company  is  solvent  it  must  live  up  to  its  rental 
contracts.  The  contract  is,  however,  made  with  the  old  com- 
pany, and  constitutes  no  lien  upon  its  property.  That  is 
segregated  for  the  protection  of  other  creditors.  The  lessor 
is  an  unsecured  creditor,  and  can  be  dealt  with  as  such.  The 
company  which  takes  over  the  property  at  a  foreclosure  sale 
is  entirely  free  from  all  the  lease  obligations  of  its  pre- 
decessor. Bankruptcy  has  wiped  out  the  score.  The  new 
company  need  assume  only  such  contracts  as  its  reorganizers 
consider  to  be  necessary  to  its  success.  The  receiver  has 
usually  terminated  or  modified  unprofitable  lease  contracts, 
and  the  reorganization  committee  has  only  to  follow  in  his 
footsteps.  If  a  leased  line  has  proven  unprofitable,  the  re- 
organization committee  can  either  dispense  with  it,  or,  if  it 
is  retained,  its  rental  can  be  reduced.  The  reorganization 
committee  has  a  free  hand.  They  cannot  be  held  to  old  agree- 
ments. Old  contracts  have  lapsed  and  must  be  renewed  by 
the  new  company  before  they  can  become  binding  upon  it. 

The  history  of  railroad  reorganization  contains  notable 
examples  of  the  termination  of  lease  contracts.    The  reorgan- 

*  "  Railroad  Reorganization,"  Stuart  Daggett,  p.  357. 


450  CORPOKATION   FINANCE 

ization  of  the  Wabash  in  1886  resulted  in  a  reduction  of  1,541 
miles  of  leased  lines,  and  the  Richmond  &  West  Point  Ter- 
minal reorganization  lopped  off  4,479  miles.  A  more  com- 
mon method  than  the  reduction  of  mileage  is,  however,  the 
reduction  of  rentals.  In  the  railway  field,  the  owners  of 
leased  lines  have  usually  no  choice  but  to  accede  to  any  rea- 
sonable proposition  of  the  reorganization  committee  for  a  re- 
duction in  their  rentals.  Their  property  is  usually  of  little 
value  outside  of  a  large  railway  system,  and,  as  a  rule,  the 
system  with  which  it  is  most  valuable  is  that  with  which  it 
is  already  connected.  From  1892  to  1898,  the  net  reduction 
in  lease  rentals  for  American  railways  was  $24,527,000,  a 
large  part  of  this  representing  reductions  in  reorganizations. 
A  portion  also  represented  the  acquisition  of  leased  lines,  and 
the  consequent  conversion  of  rentals  into  interest. 

We  come  now  to  the  reduction  of  interest.  Just  as 
holders  of  some  of  the  bonds  may  have  been  obliged  to  make 
sacrifices  by  subscribing  to  new  securities,  so  they  may  also 
be  required  to  sacrifice  some  of  their  claims  for  interest  in 
order  that  the  solvency  of  the  new  company  may  be  secured. 
This  reduction  of  interest  is  accomplished  in  the  exchange 
of  the  securities  of  the  old  company  for  the  securities  of  the 
new  company.  The  methods  by  which  such  an  exchange  is 
accomplished  have  been  already  suggested.  The  new  com- 
pany offers  its  securities  for  subscription,  in  part  in  cash, 
and  in  part  in  the  securities  of  the  old  company.  If  the 
old  company  has  not  been  able  to  pay  interest  on  $10,000,- 
000  of  second  mortgage  bonds,  and  if  it  is  desired  to  elimi- 
nate this  interest  charge  from  the  income  account  of  the 
new  company,  the  new  company  may  offer  the  holders  of 
the  second  mortgage  bonds,  $10,000,000  of  preferred  stock  to 
be  paid  for  with  their  bonds. 

Some  of  the  creditors  of  the  old  company  must  make 
sacrifices.  Some  of  its  bonds  must  be  disturbed.  Which 
bonds  shall  be  disturbed?  How  shall  their  claims  be  modi- 
fied and  what  compensation  shall  they  be  given  for  their 
sacrifices?    Let  us  reverse  the  inquiry  and  ask  what  are  the 


KEORGANIZATION   OF   CORPORATIONS      45I 

bonds  which  are  not  disturbed  in  a  reorganization?  In 
every  reorganization  we  find  some  of  these  bonds.  Take  the 
Erie,  for  example;  it  has  five  divisional  mortgages  ranging 
from  first  to  fifth  on  portions  of  the  line  which  lie  within 
the  State  of  New  York.  These  mortgages  have  survived 
three  reorganizations,  not  being  disturbed  by  any  of  them. 
In  the  same  way,  the  Norfolk  &  Western  Railroad,  the  Read- 
ing, the  Baltimore  &  Ohio,  have  carried  through  their  re- 
organizations certain  issues  of  bonds,  without,  in  any  way, 
disturbing  them  save,  in  some  cases,  to  consolidate  them  by 
making  attractive  conversion  offers  into  large  issues.  These 
bonds  are  safe  from  the  reorganization  committee  for  the 
reason  that  their  interest,  even  in  the  worst  years,  has  been 
fully  earned.  Even  the  receivers  have  recognized  their  claims 
and  have  paid  their  interest.  Bonds  secured  by  mortgages 
upon  important  branch  roads,  terminal  property  or  equip- 
ment, do  not  suffer  in  a  reorganization  for  the  reason  that 
there  is  no  way  to  get  at  them.  The  property  which  secures 
them  is  indispensable  to  the  company.  Unless  the  rights 
of  these  holders  are  properly  recognized  they  may  inflict  se- 
rious damage  upon  the  system  by  seizing  the  property  which 
secures  their  bonds. 

It  may,  however,  be  necessary  for  the  holders  of  first 
mortgage  bonds,  even  though  their  interest  has  been  fully 
earned,  to  subordinate  their  lien  to  the  lien  of  a  new  first 
mortgage,  without  which  the  necessary  money  cannot  be  se- 
cured. Along  with  this  sacrifice  may  also  go  a  reduction 
in  their  interest  claims.  Speaking  generally,  however,  the 
holders  of  first  mortgage  bonds  whose  interest  has  been 
earned,  are  not  called  upon  to  sacrifice  their  interest  in  re- 
organizations. In  companies  which  present  a  complication 
of  securities;  first  mortgages,  divisional  mortgages,  general 
mortgages,  debentures,  etc.,  the  sacrifices  in  interest  are  usu- 
ally apportioned  according  to  the  extent  to  which  the  differ- 
ent bonds  have  participated  in  the  net  earnings  of  the  com- 
pany. The  net  earnings  of  the  company  are  taken  as  the 
basis  of  the  new  fixed  charges,  and  the  reorganization  com- 


452  CORPORATION  FINANCE 

mittee  apportions  the  net  earnings  among  the  various  dis- 
turbed securities  according  to  the  amount  which  the  property 
back  of  each  security  has  contributed  to  the  total.  In  so  far 
as  the  interest  on  a  bond  has  been  earned,  this  absolute  lien, 
as  a  rule,  has  been  retained.  In  so  far  as  its  interest  has  not 
been  earned,  the  bond  is  reduced  to  its  true  position  as  pre- 
ferred stock,  a  form  of  security  whose  return  is  not  guaran- 
teed, but  is  conditioned  on  the  future  earnings  of  the  company. 
The  method  employed  in  this  reduction  is  illustrated  by  a 
statement  made  by  the  reorganization  committee  of  the  Atchi- 
son in  the  reorganization  of  1895  with  reference  to  the  posi- 
tion of  the  general  mortgage  bonds  in  the  reorganization : 

"  After  making  a  careful  estimate  as  to  how  much  of  the 
existing  lines,  if  retained  in  the  system,  could,  under  the 
circumstances,  be  avoided,  or  if  these  lines  be  left  out,  what 
amount  the  Atchison  system  would  be  able  to  earn  without 
the  auxiliary  lines,  the  committee  has  arrived  at  the  con- 
clusion that  it  would  not  be  safe  to  place  upon  the  property 
a  fixed  charge  of  more  than  four  per  cent  upon  seventy-five 
per  cent  of  the  principal  of  the  present  general  mortgage 
bonds." 

The  situation  of  holders  of  general  mortgage  bonds  whose 
interest  has  not  been  earned  is  here  exactly  stated.  Since 
the  company  cannot  earn  their  interest,  they  cannot,  in 
reason,  refuse  to  consent  to  a  reduction  of  fixed  income. 
Suppose  they  should  refuse,  what  can  they  do?  The  only 
alternative  is  to  foreclose  the  mortgage.  To  do  this,  they 
must  raise  enough  cash  to  pay  off  all  the  prior  liens,  for  their 
mortgage  is  spread  over  and  is  subordinate  to  the  claims 
superior  to  their  own.  This  is  practically  impossible,  so 
their  only  course  is  to  submit,  after  holding  out,  as  long  as 
possible,  for  better  terms.  It  is  true  that  there  is  always  the 
final  resort  to  the  courts,  who  may,  at  any  time  before  the 
recording  of  the  new  securities,  hold  up  the  whole  proceeding 
by  injunction.     This  will  be  done,  if  it  can  be  shown  to  the 


REORGANIZATION   OF   CORPORATIONS      453 

satisfaction  of  the  court  that  any  interest  is  being  unjustly 
treated.  Such  interference,  however,  cannot,  unless  in  cases 
of  the  most  flagrant  injustice,  be  secured  by  a  minority.  If 
a  large  majority  of  the  bonds  are  deposited,  the  courts  will 
usually  refuse  to  interfere,  holding  that  the  consent  of  the 
majority  should  be  binding  upon  all.  The  contest  over  the 
Erie  reorganization  in  1895  offers  an  illustration.  A  plan 
had  been  proposed  which  seemed  unfair  to  the  second  mort- 
gage bondholders.  Nevertheless  eighty  per  cent  of  these  bonds 
had  been  deposited,  when  a  suit  was  brought  in  the  New 
York  Superior  Court  to  enjoin  the  company  from  recording 
the  mortgage.  The  court  refused  to  grant  the  injunction 
on  the  ground  that  the  consent  of  so  large  a  majority  of  the 
parties  in  interest  had  made  the  plan  already  operative,  and 
as  minority  should  not  interfere. 

The  nature  of  preferred  stock  has  already  been  fully 
explained.^  Dividends  on  the  preferred  stock  are  payable  out 
of  net  earnings  after  the  expenses  of  operation,  repair  and 
betterments,  interest  on  the  funded  debt,  rentals  and  taxes, 
the  necessary  cost  of  operating  the  business  and  keeping  it 
out  of  the  hands  of  the  receiver,  have  been  paid.  The  fixed 
charge  of  a  mortgage  bond  whose  interest  must  be  paid,  or 
foreclosure  results,  but  which  the  company  cannot  earn  in  jus- 
tice to  its  physical  condition  and  under  the  circumstances  of 
its  business,  is  converted  into  a  cl^im  whose  payment  is  con- 
ditioned upon  the  net  earnings  of  the  company.  In  the  ex- 
change of  bonds  on  which  interest  is  not  earned,  for  preferred 
stock  in  the  reorganized  company,  the  relation  of  the  former 
creditors  to  the  property  is  defined  precisely.  The  element 
of  risk  which  they  assumed  when  they  purchased  the  junior 
lien  bonds  is  exactly  expressed  in  the  contract  which  sets  forth 
the  relation  of  the  preferred  stockholder'  to  the  company. 

The  position  of  the  junior  bondholder  is  improved  by  the 
conversion  of  his  bonds  into  preferred  stock.  Before  the  con- 
version, he  is  occasionally  exposed  to  the  risk  of  receivership 
which  would  depress  the  value  of  his  securities,  and  cut  off  his 
income.     By  converting  his  junior  lien  bond  into  preferred 


454 


CORPOEATION   FINANCE 


stock,  he  enables  the  company  to  preserve  its  solvency  and  im- 
prove its  credit,  and  he  places  it  in  a  position  where  it  cannot 
only  earn  interest  but  pay  him  his  preferred  dividends.  With 
the  two  exceptions  of  the  Southern  and  the  Erie,  and  these  are 
only  partial  exceptions,  the  preferred  stocks  issued  in  the  re- 
organizations referred  to  in  the  following  table  have  paid 
dividends  for  many  years.  If  they  retain  these  stocks,  the 
former  bondholders  have  fully  recovered  the  losses  caused  by 
the  defaults  which  led  to  these  reorganizations. 

The  extent  to  which  the  conversion  of  junior  bonds  into 
preferred  stock  was  employed  during  the  great  railway  reor- 
ganizations following  the  panic  of  1893  is  shown  in  the  follow- 
ing table : 


Name  op  Road 


Atchison,  Topeka  and  Santa  Fe 
Erie  \  First  preferred. .  . 

I  Second  preferred 

Norfolk  and  Western 

Northern  Pacific 

Oregon  Railway  and  Navigation 
Company 

"■"•U-^ ISSfoS'^Sed 

St.  Louis  and  J  First  preferred  . 
San  Francisco  1  Second  preferred 
Southern  Railway 

Totals 


Amounts  of  Prefehhed  Stock  Issued 


For  Old 
Bonds 


$96,740,000 

27,146,000 

7,271,000 

22,833,000 

54,880,000 

9,290,000 
7,184,000 

40,286,000 
8,214,000 
8,214,000 

32,887,000 


$314,945,000 


For  Stock 


$8,537,000 


For  As- 
sessments 


17,620,000 


8,799,000 


$13,717,000 


1.440,00C 


1.150,000 


7,814,000 


$34,956,000      $24,121,000 


Miscel- 
laneous 


$9,200,000 

2.854,000 

192,000 

167,000 

2,500.000 

270.000 
20,816,000 
1,714,000 
3,850,000 
7,786.000 
4,800,000 


$54,149,000 


The  bondholders  may  also  be  required  to  accept  a  lower 
rate  of  interest,  or  to  postpone  their  interest  altogether  for 
a  series  of  years,  or  to  take  a  low  rate  of  interest  with  a  gradu- 
ally ascending  rate,  or  to  receive  a  portion  of  their  principal  in 
mortgage  bonds  and  the  balance  in  some  junior  security. 
In  most  cases,  the  reorganization  committee,  as  an  induce- 
ment to  security  holders  to  accept  a  reduction  in  their  claim 
for  fixed  interest,  offers  them  a  bonus  in  some  other  security. 
If  general  mortgage  bondholders,  for  example,  are  asked 
to  receive  one  half  of  the  principal  in  first  mortgage  bonds 


KEORGANIZATION   OF   CORPORATIONS      455 

of  the  new  company,  and  preferred  stock  for  the  balance, 
they  may  be  given  $500  in  new  first  mortgage  bonds  and 
$750  or  $1,000  in  new  preferred  stock.  The  principal 
amount  of  their  securities  is,  by  this  operation,  increased. 
If  the  prospects  of  reviving  business  materialize,  and  the 
new  management  is  efficient,  the  reorganization  may  prove 
to  them  to  have  been  a  blessing  in  disguise.  An  increase 
of  capitalization  is  a  feature  which  usually  accompanies  a 
reduction  of  fixed  charges  in  the  reorganization. 

In  concluding  the  discussion  of  the  exchange  of  securities, 
two  illustrations  may  be  given,  showing  the  distribution  of 
the  securities  of  the  Northern  Pacific  and  the  Norfolk  and 
Western  in  their  respective  reorganizations,  both  of  which 
were  accomplished  in  1896. 

An  examination  of  these  tables  shows  that  so  far  as  the 
specific  security  of  the  property  back  of  each  bond  had  con- 
tributed the  amount  of  the  interest  on  the  bonds  to  the  net 
earnings  of  the  system,  to  that  extent  it  was  exchanged  for 

I.    BASIS    OF   EXCHANGE   OF  THE  SECURITIES  OF  THE 

NORFOLK  &  WESTERN  RAILWAY  IN    THE 

REORGANIZATION  OF  1896 


Old  Company 

New  Company 

Name  op  Security 

6 

i 

lis 

& 

P 

& 

Ig 

go 

1 

Adjustment  mortgage,  seven  per  cent  bonds 

7 

130 

62H 

70 

50 
100 

■55" 
35 

20 
75 
G7H 
70 
48 
100 
65 
65 

Maryland  and  Washington  Division  bonds 

Chester  Valley  Division  bonds        .    . . 

Five  hundred  and  ninety  debentures  of  1892 

Roanoke  and  Southern  Railway  bonds. 

Lynchburg  and  Durham  Railway  bonds 

Norfolk  and  Western  common') 
Norfolk  and  Western  preferred  I  Assessment  $12.50 
Roanoke  and  Southern  Stock  |          per  share 
Lynchburg  and  Durham  Stock 

}■•■■ 

(76" 

175 
L75 

456 


COEPOKATION   FINANCE 


II.    B.\SIS  OF  EXCHANGE  OF  THE  SECURITIES    OF  THE 

NORTHERN  PACIFIC  IN  THE  REORGANIZATION 

OF    1896 


Old  Company 

New  Company 

Name  op  Security 

6 

6 

^  0 

.u 

0)  CU  t' 

^  0 

^1 

111 
1? 

General  first  mortgage  bonds  ...  ,1, 

General  second  mortgage  bonds    .  .     

3 
4 
3 
3 

iM 

135 

ioo" 

118 
663^ 

ho" 

50 
50 

20 
50 

,1 

General  third  mortgage  bonds 

Dividend  certificates        

Consolidated  mortgage  bonds 

Collateral  trust  notes 

Northwest  equipment  stock .  . 

100 

Depositors  of  preferred  stock  on  payment 
of  $10  per  share 

50 

Depositors  of  common  stock  on  payment 
of  $15  per  share 

100 

new  mortgage  bonds.  In  so  far  as  its  interest  had  not  been 
earned,  preferred  stock  was  given,  usually  to  an  amount 
greater  than  the  par  value  of  the  securities  which  it  displaced. 
The  principle  of  apportionment  is  especially  well  illustrated 
in  the  Norfolk  &  Western  reorganization.  The  bonds  of  four 
branch  roads  were  disturbed.  Of  these,  the  Maryland  and 
Washington,  and  Roanoke,  and  Southern  had  earned  more 
than  the  other  two,  and  their  greater  earning  ability  was  rec- 
ognized in  larger  proportions  of  preferred  stock.  The  100- 
year  mortgage  bonds  also,  whose  interest  had  not  been  fully 
earned,  were  cut  down  25  per  cent,  but  55  per  cent  in  first 
preferred  stock  was  given  in  exchange,  so  that  in  the  long  run 
the  bondholders  were  no  losers,  the  preferred  stock  in  1898 
having  sold  for  63|^.  In  the  same  way,  the  holders  of  the  con- 
solidated mortgage  bonds  of  the  Northern  Pacific  received  62J 
per  cent  in  new  prior  lien  bonds,  and  62J  per  cent  in  preferred 
stock.  In  1895,  before  the  reorganization,  the  consolidated 
bonds  did  not  rise  above  36,  while  in  December,  1898,  two 
years  after  the  reorganization,  the  prior  lien  bonds  sold  for 


REORGANIZATION   OF   CORPORATIONS      457 

93,  and  the  preferred  stock  for  78.  In  exchange  for  a  bond 
worth  $360,  the  Northern  Pacific  bondholders  received  an- 
other bond  worth,  two  years  later,  $642,  besides  $780  in  pre- 
ferred stock. 

One  more  feature  of  reorganization  plans  demands  atten- 
tion. The  bondholders  have  controlled  the  reorganization 
and  have  made  sacrifices  in  order  that  the  plan  might  be 
successful.  They  insist,  as  a  condition  of  their  participation, 
that  they  should  receive  some  guarantee  of  the  quality  of 
the  management.  The  stock  of  the  new  company,  if  placed 
upon  the  market,  will  command  a  low  figure.  It  may  fall 
into  the  hands  of  speculators  who  may  exploit  the  property 
for  their  own  benefit.  The  bondholders  fear  that  they  may 
have  another  default  to  suffer,  another  floating  debt  to  take 
care  of.  To  guard  against  this  danger,  it  is  almost  invari- 
ably provided  that  the  stock  of  the  reorganized  company 
shall  be  placed  for  a  series  of  years  in  the  hands  of  trus- 
tees who  will  issue  to  the  holders  securities  of  beneficial 
interest  in  any  dividends  which  may  be  paid  on  the  stock, 
the  voting  power,  however,  remaining  with  the  trustees. 

The  nature  of  a  voting  trust  provision  is  indicated  by 
the  following  extract  from  the  reorganization  plan  of  the 
Pope  Manufacturing  Company: 

"All  of  the  stock  of  the  new  company  except  directors' 
qualifying  shares  will  be  issued  to  voting  trustees,  who  shall 
issue  to  the  various  persons  entitled  to  receive  said  stock 
suitable  certificates  containing  an  agreement  to  deliver  said 
stock  on  or  after  August  1,  1911,  or  sooner  if  the  voting 
trustees  shall  so  determine,  and  in  the  meantime  to  pay  to 
such  persons  an  amount  equal  to  any  sums  received  as  divi- 
dends upon  said  shares  of  stock.  During  the  continuance 
of  the  aforesaid  voting  trust  (1)  no  mortgage  shall  be  put 
upon  the  property  (other  than  the  mortgage  herein  referred 
to)  except  with  the  consent  of  the  holders  of  two  thirds  in 
amount  of  each  class  of  stock;  (2)  the  amount  of  preferred 
stock  shall  not  be  increased  except  with  the  consent  of  the 


458  COKPOKATION   FINANCE 

holders  of  three  fourths  in  amount  of  the  certificates  rep- 
resenting preferred  stock  and  the  holders  of  two  thirds  in 
amount  of  certificates  representing  common  stock;  (3)  the 
amount  of  common  stock  shall  not  be  increased  except  with 
the  consent  of  the  holders  of  two  thirds  in  amount  of  the 
certificates  representing  preferred  stock  and  the  holders  of 
two  thirds  in  amount  of  the  certificates  representing  com- 
mon stock." 

By  this  provision,  not  only  were  the  interests  of  creditors 
safeguarded  by  the  placing  of  control  for  a  period  of  three 
years  in  the  hands  of  trustees,  but  the  stockholders  were  as- 
sured against  any  abuse  of  their  power  by  the  voting  trustees. 

These  voting  trust  certificates,  when  issued  on  behalf  of 
large  public  corporations,  are  listed  on  the  public  exchanges, 
and  are  dealt  in  exactly  as  are  shares  of  stock.  The  voting 
trustees  are  usually  named  by  the  banking  firm  which  car- 
ries through  the  reorganization.  They  represent  primarily 
the  creditors'  interest.  Their  ^administration  has  been  gen- 
erally successful  and  they  have  materially  assisted  in  restor- 
ing to  public  confidence  the  corporations  for  whose  man- 
agement they  have  been  made  responsible. 


INDEX 


Accountant,  work  of,  171. 

Act  creating  Public  Service  Cora- 
mission,  extract  from,  73. 

Addy stone  Pipe  and  Tube  Com- 
pany, case  of,  353. 

Allis  Chalmers  Company,  as  ex- 
ample, 124. 
stock  of,  125. 

Amalgamated  Copper  Company, 
stock  of,  125. 

American  asphalt  promoter,  suc- 
cess of,  149. 

American  Car  and  Foundry  Com- 
pany, promotion  of,  35. 

American  Piano  Company,  pro- 
vision of  charter  of,  294. 

American  Sheet  Steel  Company, 
consolidation  of,  35. 

American  Smelting  and  Refining 
Company,  as  example,  228. 
stock  of,  125. 

American  Street  Railway  Asso- 
ciation, report  of,  219. 

American  Tin  Plate  Company, 
purpose  of  organization  of, 
34. 

American  Tobacco  Company,  case 
of,  in  Circuit  Court,  South- 
ern District  of  N.  Y.,  Judge 
Lacombe,  364. 

Arnold  Print  Works,  plan  of, 
443. 

Assessable,  stock,  character  of, 
103,  104. 


Assessment,  discussed,  439. 

Assets,  disposition  of,  385. 

Assets  and  liabilities,  statement 
of,  172,  173. 

Associated  Merchants  Company, 
the,  as  example,  99. 

Atchison  reorganization,  as  ex- 
ample, 448,  452. 

Atchison  stock,  as  example,  309. 

Baldwin   Locomotive    Works,    as 

illustration,  268. 
Baltimore   &   Ohio   Railroad,   as 
example,  227,  248. 
mileage  of,  1. 
policy  of  receiver  of,  423. 
problem  of,  421,  422. 
receivers  for,  421. 
Bank  deposits,  interest  on,  204. 
Bank  loans,  when  paid,  298. 

why  made,  297. 
Bankers,  attitude  of,  toward  pro- 
moters, 14. 
Bankrupt  corporations,  reorgan- 
ization of,  425. 
Bankruptcy,      causes      of,      436, 

437. 
Banks,    extension    of    credit    of, 

298. 
Belmont,    Mr.    August,    case    of, 

278. 
Bituminous  coal,  locality  of,  6,  7. 

production  of,  1. 
Bondholder,  interest  of,  62. 
459 


460 


INDEX 


Bond  issue,  determining  the  ex- 
pediency of,  291. 
restrictions  of,  71. 
Bonds,  amount  of,  which  can  be 
issued,  64,  65. 
as  form  of  security,  51. 
bought  for  sinking  fund,  86. 
conversion  of,  into  stock,  397. 
drawings  of,  85. 
form  of,  52. 
illustration  of,  75. 
methods  of  disposing  of,  88. 
provision  for  repayment  of,  81. 
rate  of  interest  to  be  fixed  on, 

78. 
repayment  of,  at  maturity,  82. 
sale  of,  at  a  discount,  79. 
term  of,  77. 
Boston    &    Maine,    as    example, 

342. 
Boston    Consolidated    Gas    Com- 
pany, as  example,  337. 
Boston    Electric    Railway    Com- 
pany, provisions  of,  381. 
stipulation  of  lease  of,  381. 
Broker,  method  of,  151. 
Burlington    stock,    as    example, 

325. 
Bush,  President,  quoted,  407. 
Business    corporations,     purpose 
of,  203. 

California     Electric     Generating 

Company,  as  example,  319. 
Capital  a-count,  readjustment  of, 
383. 
table,  401. 
Capital     stock,     illustration    of, 
385,  386. 
increase  of,  385. 
reduction  of,  386. 
Car  maintenance,  objects  of,  220, 
221. 


Car  maintenance,  table  of  costs 

and  credits  for,  222. 
Carnegie,  Mr.,  92. 

success  of,  45. 
Carnegie  Steel  Company,  growth 
of,  268. 
plan  of,  339. 
Cassatt,   President,   quoted,   257, 

259. 
Central    Union    Telephone    Com- 
pany, as  illustration,  255. 
letter  of  President  of,  255. 
Chicago  &  Alton  Railroad  Com- 
pany, explanation  of  action 
of    (by  Paul  Cravath),  244, 
245. 
method  of,  244. 
Chicago  &  Great  Western,  as  ex- 
ample, 431. 
plan  set  forth  to  stockholders 

in,  437,  438. 
statement  of,  437,  438,  439. 
Chicago     Bell     Telephone     Com- 
pany, as  example,  67,  69. 
Chicago    Railway    Company,    as 

example,  75. 
Chicago,  Rock  Island  &  Pacific, 

as  example,  328,  391. 
Chicago    Union    Traction    Com- 
pany,   rates    for    equipment 
of,  197. 
Closed  mortgages,  form  used  by, 
314. 
kinds  of,  314. 
Cluett,     Peabody     &     Company, 

plan  of,  243. 
Collateral  trust  bond,  explained, 
313. 
purpose  of,  326,  327,  328. 
security  of,  324. 
value  of,  323. 
Collateral  trust  debentures,  fram- 
ing of,  325. 


INDEX 


461 


Collateral  trust  mortgages,  safe- 
guards of,  324. 
Colorado    Fuel    and    ^ron    Com- 
pany, agreement  of,  307. 
necessity  of,  385. 
Combination,    advantage    of,    31, 
34. 
discussed  by  Mr.  Gates,  28. 
power  of,  28. 
Commission  of  the  Second   Dis- 
trict   of    N.    Y.,    method    of 
procedure  of,  74. 
Committee     for     reorganization, 
method  of  forming,  428. 
powers  of,  428. 
Common  stock,  discussed,  100. 
how  sold,  386. 
premiums  of,  279,  280. 
sale  of,  279. 
Common     stockholders,     receipts 

of,  50. 
Competition,    attempt    to    elim- 
inate, 235. 
Concrete,  use  of,  2. 
Conducting  transportation,  items 

of,  177. 
Consolidated    Oil    Company,    as 

example,  123,  124. 
Consolidation,  second  method  of, 

338. 
Construction  companies,  descrip- 
tion of  operation  of,  112-1     . 
transaction  of,  110-112. 
use  of,  117. 
work  of,  109. 
Convertible  bonds,  a  feature  of, 
308. 
advantages  of,  308. 
price  of,  309. 
Convertible    debentures,    use    of, 

311. 
Corporate  bond^.  endorsement  of, 
319. 


Corporate    guarantee,    kinds    of, 

319. 
Corporate    income,    management 

of,  208. 
Corporate       indorsements       and 
guarantees,  explained,  318. 
use  of,  319. 
Corporate    leases,    provision    of, 

373. 
Corporation,  defined,  48,  49. 
position  of,  regarding  common 
stock,  290. 
Corporation    bond,    defined,    51, 

81. 
Corporation     law    of    Germany, 

prohibition  by,  136. 
Corporation    laws    of    State    of 

N.J.,  358. 
Corporation    stocks,    disposition 

of,  170. 
Corporations,      bankruptcy      of, 
406. 
consolidation  of,  336. 
factors  in  earnings  of,  226. 
position  of,  regarding  common 

stock,  102. 
where  organized,  405,  406. 
Covenants,     failure     of    railway 

company  to  perform,  57. 
Creditors,  opposition  of,  420. 
secured,  407. 
unsecured,  407. 
Cudahy  Packing  Company,  mort- 
gage of,  85. 
Cumulative    preferred,    security 

of,  341. 
Cunard    Company,    as    illustra- 
tion, 242. 
Cutting,  Henry,  success  of,  139. 

Dagget,  Dr.  Stuart,  441. 
Debenture  bond,  defined,  304. 
illustration  of,  304. 


462 


INDEX 


Debenture    bond,    special    securi- 
ties of,  305. 
value  of,  304. 
Debt,  issue  of  evidences  of,  297. 
Debt  liabilities,  readjustment  of, 

390. 
Delano,  Dr.  Fred.  A.,  discussion 

by,  199. 
Demand  loans  of  New  York  City 

banks,  amount  of,  154. 
Depreciation,      accounting      for, 
191,  192,  193,  194. 
causes  of,  189. 

difficulty  in  estimating,  198. 
discussed,  188. 
financing  of,  223. 
illustration  of,  189,  190. 
losses  due  to,  190. 
Wisconsin      commission      pro- 
vision for,  223. 
Directors,    problem    confronting, 

215. 
Discounts     on     securities,     how 

treated,  205. 
Distribution  on  stock,  rules  gov- 
erning, 212. 
Dividends,  defined,  208. 

of  different  corporations,  208. 
rate  of,  212,  221. 
withholding  of,  270. 

Earnings,  stability  of,  22,  63. 
Edson,    President,    quoted,    265, 

266. 
Engineers,  method  used  by,  10. 

mistakes  of,  10,  11. 
Equipment    trust    bond,    use    of, 

334. 
Erie,  as  example,  387,  451. 
Erie  bondholders,  proposition  to, 

394. 
statement  to,  394,  395. 
Expenditures,  discussed,  254. 


Falling  prices,  effect  of,  230. 
Fields,  Marshall,  as  illustration, 

268. 
Finance  holding  company,  collat- 
eral trust  bonds  of,  369. 
Electrical  Securities  Company 

as,  368. 
purposes  of,  370. 
Financial  plan,  materials  of  the, 

47. 
Fish,  Mr.  Stuyvesant,  support  of, 

285. 
Fixed  charges,  division  of,  449. 
Flint,  Mr.,  quoted,  38. 
Ford,  Mr.  Frank  R.,  quoted,  223, 

224. 
Funding    floating    debt,    method 

of,  392. 

Gates,   John   W.,   campaigns   of, 
278. 
quoted,  28. 

General  Corporation  act  of  N.  J., 
section  of,  106,  107. 

General  Electric  Company,  meth- 
od employed  by,  386. 

General   mortgage   bonds,    situa- 
tion of  holders  of,  452. 

Girard    Trust    Company,    agree- 
ment to,  332. 

Golden,  Frank,  success  of,  139. 

Great  Northern  Road,  policy  of, 
241. 

Guarantee,    objections    to,    321, 
322. 

Guarantee    Trust    Company,    as 
example,  315. 
summary  of,  333. 

Harriman,  E.  H.,  aid  of,  to  the 
Erie,  303. 
description  of  security  by,  316, 
317. 


INDEX 


463 


Harriman,  E.  H.,  difficulty  expe- 
rienced by,  285. 

testimony  of,  384. 
Holding    companies,    advantages 
of,  367. 

described,  346. 

examples  of,  366,  367. 

illustrations  of,  370. 

methods  of  forming,  366,  367. 

purpose  of,  365,  366. 

uses  of,  367. 

why  formed,  346. 
Hudson     River     Electric     Power 
Company,     as      illustration, 
396. 

Illinois    Steel    Company,    orders 
of,  350. 

Income  account,  item  of,  203. 

Industries,  classification  of,  61. 

Industry,  growth  of,  4. 

Interest,  reduction  of,  450. 

International      Harvester      Com- 
pany, form  used  by,  173,  174. 

International    Mercantile    Bond, 
as  example,  168. 

International     Paper     Company, 
trust  prospectus  of,  145. 

International     Silver     Company, 
statement  of,  146. 

Interstate     Commerce     Commis- 
sion, statement  of,  288. 

Interurban  Electric  R.  R.,  mile- 
age of,  2. 

Investment,  how  performed,  3. 

Investment   banker,   function   of, 
119,  120. 
work  of,  128. 

Investment  stock,  characteristics 
of,  123. 
examples  of,  22. 

Investment     trusts,     advantages 
of,  371,  372. 


Investment  trusts.  Great  Britain, 
370. 

purpose  of,  370,  371. 
Investor,  attitude  of,  6. 

interest  of,  23. 

privileges  of,  283,  284,  285. 

why  so  named,  122. 

wishes  of,  81. 

work  of,  6. 
Investors,  motives  of,  4. 

most  important,  127. 
Iron  Age,  quoted,  41,  349,  350. 

Jobber,  the,  methods  of,  30. 
Junior  bond  holder,  position  of, 

453. 
Junior  bonds,  table,  454. 

Kansas   City   Southern   Railway 
Company,     as     illustration, 
217,  218,  219. 
expenditures    necessary    to   ex- 
pand, 265. 

Keene,  James  R.,  charges  made 
by,  270. 

Knight,    E.    C,    Sugar    Refining 
Company,  363. 

Kuhn,  Loeb  &  Company,  as  ex- 
ample, 159. 

Lacombe,  Judge,  quoted,  414. 
Lake  Shore,  as  example,  34. 
Large  buyer,  advantage  of,  29. 
Lease,  advantage  of,  376. 

bonds   secured   by   the   assign- 
ment of,  330. 

definition  of,  373. 

disadvantage  of,  377. 

use  of,  330. 
Lehigh  Valley,  report  of,  274. 
Lehigh  Valley  Car  Trust  Certi- 
ficates, as  example,  330. 
Lessor,  agreement  of,  331. 


464 


INDEX 


Lessor  company,  power  of,  413. 
Liabilities,  readjustment  of,  385. 
Long  term  bonds,  kinds  of,  304. 
Lumber,  production  of,  1. 

Maintenance,  neglect  of,  217. 
Maintenance    charges,    items    of, 

215,  216. 
Maintenance    departments,    duty 
of,  182,  183,  184. 
illustration  of,  184. 
Manhattan     Railway     Company, 
provision     for     maintenance 
of,  374,  375. 
Manufacturer,  pressure  on,  32. 
Master  in  Chancery,  refusal  of, 

171. 
Merger,  explained,  336. 

method  of,  337. 
Mining  enterprises  as  basis  for 

bond  issues,  64. 
Missouri  Anti  -  Combination 

Laws,  362. 
Missouri,    Kansas    &    Texas,    as 

example,  388. 
Mitchell,    Dr.    T.    W.,    work    of, 

282. 
Monopoly,  explained,  63. 

origin  of,  63. 
Moore,   Judge   Wm.   H.,   quoted, 

34,  36,  39. 
Morgan,  J.  P.,  &  Company,  an- 
nouncement of,  429. 
as  example,  159. 
Mortgage,  defined,  52. 
example  of,  58. 
grades  of,  57,  58. 
"open  end,"  76. 
purpose  and  effect  of,  57. 
Mortgage  bond,  advantage  of,  67. 
Mortgage  Bond  Company  of  N. 
Y.,  bonds  and  mortgages  of. 


Mortgage  Bond  Company  of  N. 
Y.,  field  covered  by,  369. 
restrictions  on,  369. 
Mortgage  bonds,  discussed,  312. 

National  Enameling  and  Stamp- 
ing Company,  mortgages  of, 
85. 

New  capital,  provisions  of,  253. 

Newhouse  Mine  and  Smelters,  re- 
organization plan  of,  44. 

N.  Y.  &  Westchester  Lighting 
Company,  as  example,  320. 

N   Y.,   N.   H.   and   Hartford,   as 
example,  343. 
plan  of,  307. 

N.  Y.  Public  Service  Commis- 
sion, power  of,  76. 

N.  Y.  Stock  Exchange,  shares 
sold  on,  in  1899,  154. 

Newspaper  accounts,  139. 

Northern  Pacific  and  Norfolk 
and  Western  tables,  455,  456. 

Northern  Pacific   Railway   Com- 
pany, plan  of  capitalization 
of,  431. 
property  of,  431. 

Northern     Securities     Company, 
363. 
Northern    Pacific,    and    Great 
Northern  combination,  364, 

Ofl&cers,  duties  of,  48. 
Operating    expenses,    classes    of, 

177. 
Option,  definition  of,  15. 
Optionee,  examples  of,  16. 

rights  of,  16,  17. 
Oregon  Short  Line  R.   R.   Com- 
pany, as  example,  326. 

Pacific  Telephone  &  Telegraph 
Company,  as  example,  69. 


INDEX 


465 


Pennsylvania  Railroad,  as  exam- 
ple, 231,  233. 
gains  of,  261,  262. 
increase  of  capital  of,  256. 
policy  of,  256. 
report  of,  for  1899,  257. 
work  of,  261. 
Pennsylvania    tunnel    extension, 
money  raised  for,  5. 
object  of,  5. 
plan  of,  5. 
Philadelphia       Rapid       Transit 
Company,     as     illustration, 
378. 
letter  of,  378,  379. 
Philadelphia    &    Reading    R.    R. 
Company,  as  example,  430. 
Physical    property,    maintenance 

of,  178. 
Pig  iron,  production  of,  1. 
Pool,  how  organized,  347. 

successful  management  of,  348. 
Pooling   agreements,   pooling  of, 

351. 
Preference  shareholders,  receipts 

of,  50. 
Preferred   stock,   amount   of,   is- 
sued, 293. 
classification  of,  50. 
cumulative,  93,  94. 
dividends  on,  453. 
division  of,  51. 
issue  of,  93,  312. 
made  cumulative,  292. 
of    U.    S.    Rubber    Company, 

70. 
of  Virginia-Carolina  Chemical 

Company,  97. 
purchaser  of,  292. 
railroad,  96. 
rate  of  dividend  on,  96. 
sale  of,  290,  291. 
whom  used  by,  93, 


Preferred  stock  contracts,  a  fea- 
ture of,  295,  296. 
Preferred  stock  holder,  demands 

of,  99. 
Premium  stock,  issue  of,  287. 
Premiums,  profits  from,  204. 
Pressed  Steel  Car  Company,  re- 
port   of    President    of,    for 
1901,  263. 
"  Prima  facie,"  meaning  of,  410. 
Private  banker,  function  of,  119. 
Producer,  work  of,  3. 
Production,  capital  necessary  to, 
4. 
of  power,  opportunity  in,  2. 
of  wealth,  opportunities  for,  2. 
Profits,  determination  of,   169. 
disposal  of,  50. 
illustration  of,   229. 
making  extension  out  of,  268. 
percentage  of    (paid  to  stock- 
holders), 229. 
principles  of  making,  169. 
stability  of,  227. 
Promotor,  defined,  38. 
problems  of,  41,  42,  43. 
work  of,  6,  14,  47,  20,  21,  22, 
23,  244. 
Promoting    engineer,    advantages 

of,   12. 
Property,  non-specialized,  61,62. 

specialized,  62. 
Proprietor,  course  of,  22,  23. 
Providing  new  capital,   methods 

of,  267. 
Public       Service        Commission, 
where  found,  72. 
work  of,  72. 
Pullman    Company,    cars    leased 
from,  422. 

Railroad  balance  sheet,  contents 
of,  271. 


466 


INDEX 


Railroad  balance  sheet,  items  of 
272. 
Lehigh  Valley  terminal,  272. 
Railroad    expenses,    two    classes 

of,  177. 
Railway   and  manufacturing  in- 
dustries,   distinction    between, 
233. 
Railway    profits,    protection    of, 
234. 
stability  of,  237. 
Rates  of  depreciation,  rules  for 

establishing,  200. 
Recapitalization,     caution     used 

in,   251. 
Receiver,  authority  of,  411. 
certificates  of,  415. 
duties  of,  412. 
form  of  certificates  of,  416. 
how  money  is  obtained  by,  415. 
illustration  of,  410. 
reason     for     appointing,     409, 
411. 
Receivers'    certificates,    purposes 

of,  417. 
Receivership,  cause  of,  412. 
discussed,  404. 
reasons  leading  to,  408. 
Refunding,  methods  of,  402,  403. 
Refundinj    bonds,     economy     of, 
399. 
reason  for,  398. 
when  apcomplished,  398. 
Reorganization,   money  for,   426. 

objects  of,  426,  427. 
Reorganization  plans,  feature  of, 

457. 
Republic  Iron  &  Steel  Company, 
provision  of  mortgage  of,  70. 
recovery  of,   389. 
Reserves,  how  handled,  196, 
Revenues,  disbursement  of,  413. 
method  of,  414. 


Rising  prices,  eff'ect  of,  230. 

Roadbed    of    Pennsylvania    rail- 
way, cross-section  of,  178. 
specifications  of,  179,  180,  181, 
182. 

Roberts,  President,  quoted,  186, 
187. 

Rochester,  Corning,  and  Elmira 
Traction  Company,  as  exam- 
ple, 74. 

Rock  Island  Company,  as  exam- 
ple, 100. 

St.   Louis   &    San   Francisco,   as 

illustration,   399. 
San    Diego    Consolidated    Gas    & 
Electric  Co.,  as  example,  87, 
88. 
Seaboard   Air   Line,    adjustment 

plan  of,  442. 
Securities,  example  of,  61. 
issuing  of,  60. 
sale  of,  118. 
Security  issues,  state  supervision 

of,  72. 
Seligman,  J.   &  W.,  offer   of,  to 
holders,  400. 
syndicate  of,  400, 
Serial   bonds,   advantage   of,   89, 

90. 
Share  holders,  rights  of,  48,  49. 
Sherman     Antitrust     Law,     358, 
362,  363. 
first  suit  under,  363. 
illustration  of,  235. 
Short    term    notes,    example    of, 
302. 
security  of,  301. 
use  of,  303. 
Short     term     obligations,     illus- 
trated, 300,  301. 
Single    ownership,    forbidden    by 
federal  and  state  laws,  236. 


INDEX 


467 


Sinking   funds,    building   up    of, 
83. 
classes  of,  84. 

comparison    between    deprecia- 
tion   andj   201. 
method  of  managing,  89. 
when  needful,  84. 
Small  buyer,  trouble  of,  29. 
Speculation,  elements  of,  124. 
illustrated,  123. 
in  stock,  cost  of,  154. 
Speculative    securities,    sale    of, 

131,  144,  156. 
Speculator,  inducements  to,  140, 
141,    142. 
line  of,  143. 
why  so  named,  122. 
Speyer    &    Company,    agreement 
of,  162,  163,  286. 
plan  of,  391,  392. 
Standard  Oil  Company,  364. 
Standard    Oil    Trust,    effect    of, 
352. 
problem  solved  by,  355. 
Steel,  production  of,   1. 
Steel   strike   of   1901,   result  of, 

32,  33. 
Stock,  classes  of,  49. 
division  of,  48. 
how  reduced,  389. 
increase  of  amount  of,  277. 
issue  of,  91,  277. 
method     by     which     acquired, 

340. 
method  of  paying  for,  103. 
Stockholder,  privileges  of,  281. 
standpoint  of,  342-344. 
value  of  privileges  of,  282. 
Stockholders,    distributing    prof- 
its to,  208,  209. 
proposition  made  to,  376. 
Stocks,  average  price  of,  147. 
uncertainty  of,  153. 


Stocks  and  bonds,  by  whom  held, 

170. 
Stone    &    Webster    Corporation, 

banking  department  of,  12. 
Stotesbury,  E.  T.,  agreement  of, 

330-332. 
Strike,  International  Association 

of   Machinists',    1901,   result 

of,  33. 
Stringency  of  money,  illustrated, 

300. 
Sturgis,  C.  I.,  quoted,  197. 
Subscriber,  agreement  of,  162. 
Surplus,  illustration  of,  240. 
methods    of    distributing,    239, 

240. 
source  of,  205. 
Syndicate,     organization    of,     7, 

158,  159. 
represented  by  Mr.  Harriman, 

Stillman,       and       Mortimer 

Schiff,   249. 
Syndicate        dissolution,       illus- 
trated,  165-166. 
Syndicate  managers,  methods  of, 

137-138. 
work  of,  7,  8,  9,  160,  161. 
Syndicate    transactions,    feature 

of,  164. 

Thermos  bottle,  possibilities  of,  2. 
Transportation  and  manufactur- 
ing industry,  distinction  be- 
tween, 233. 
Trust  certificates,  how  dealt  in, 

351. 
Trust   promoter,   proposition   of, 
25,  26. 
work  of,  27. 
Trustees,  authority  of,  404. 
in  case  of  default,  59. 
duties  of,  48. 
work  of,  351. 


468 


INDEX 


Trusts,  attack  on,  353,  354. 

changes  in,  356. 

difference  between  old  and 
new,  360. 

examples  of:  Sugar  Trust, 
American  Refining  Com- 
pany, 360,  361. 

New  York  laws  governing, 
359. 

New  Jersey  laws  governing, 
359,  360. 

promotion  and  evolution  of, 
25. 

propositions  (3)  for  the  ap- 
portionment of  interest  in, 
36,  37,  38. 

reason  for  formation  of,  27. 

reconstruction  of,  362. 

results  of  attack  on,  354. 
Typical  promotion,  principles  of, 
19. 

represented    19. 

Underwood,  President,  announce- 
ment by,  392. 

Underwood  Typewriter  Com- 
pany, provision  of  charter 
of,  293,  294. 

Underwriter,  demands  of,  136, 
137. 

Underwriting,  work  of,  157. 

Union     Pacific     Railroad     Com- 
pany, as  example,  317,  324. 
mortgage  of,  315. 

Union  Traction  Company,  propo- 
sition made  to,  38. 

United  States  Rubber  Company, 
argument  of,  341. 

United  States  Shipbuilding  Com- 
pany, as  example,  448. 

United  States  Steel  Corporation, 
92.  \  _  ^ 

or 


United  States  Steel  Corporation, 
as    example,    214,    232,    270, 
342. 
development  of,  25. 
failure    of,    regarding    prices, 

236. 
report  of,  171. 
stability  of  prices  in,  234. 
table  of  profits  of,  225. 
United  Verde  Mine,  dividends  of, 

136. 
Utica  &  Mohawk  Valley  R.  R., 
mortgage  of,  69. 

Wall   Street   Journal,   on   indus- 
trial shares,  155 
questions  of,  132. 
Walter,  Mr.,  work  of,  274. 
Wanamaker,    John,    as    illustra- 
tion, 268. 
Wash  sales,  meaning  of,  155. 
West    End    Street    Railway,    ex- 
penditures allowed,  382. 
Western  Maryland,   as   example, 
446-447. 
reorganization  of,  431. 
Westinghouse   Electric   &   Manu- 
facturing   Company,    as    ex- 
ample, 70,  444. 
cause   of   receivership   of,   264. 
proposition  of,  to  stockholders, 

434,  435,  436. 
situation  of,  436. 
stocl;  of,  ,125. 
Whiskey  trust,  failure  of,  352. 
Whitridge,  Frederick  W.,  report 

of,  418,  419. 
Wire    Nail    Association,    method 
of  348. 
weakness  of,  348. 
Working     capital,     changes     in, 
384. 


(1) 


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